The Dividend Illusion: Sorry, Stocks Are Not Like Bonds

Some people balk when I call dividends an ‘illusion’ or refer to them as a kind of investment ‘myth’ – and they are right to be skeptical at first: after all, dividend payouts are the means by which companies transfer wealth to the people who own their stocks. But the truth is more complicated, as some people place too much faith in the payout and ignore the fact that growth is growth, whether it comes in the form of dividends or not.

What the title is alluding to is a kind of psychological blind spot – a mental trap many investors find themselves falling into – which leads them to dividend-centric investing at the expense of tax efficiency, risk management and general diversification. Most of all, stocks are not replacements for bonds. While vastly oversimplified, the above graphs illustrate the story very well: broadly speaking, dividend-payers are not that different from non-dividend-paying stocks as a class in terms of volatility or returns – and are, at least, much more like other equities than they are like bonds.

Ah, but it is never quite that easy. There are differences, and at times dividend-paying stocks will outperform – at others, they will under-perform. But that is beyond the scope and point of this article, which simply aims to dispel the notion that dividend-paying equities are somehow magically immune to downturns. If it taught investors nothing else, the crash of 2008/2009 should have illustrated the dangers in such thinking – peak to trough, dividend-paying stocks lost most of the 50% the broad market lost, while Treasury bonds spiked by 5% to 45%, depending on duration.

Moreover, over long periods, dividend strategies should pay less if they are less risky – otherwise, there would be a free lunch (which the at least semi-efficient market tends to eat quite quickly). At least in the case of this example, the return trade-off appears to hold true over at least this (randomly-selected from present back to the origins of the fund in question) graph shows:

It is easy to see how this misunderstanding evolved. Some investors see dividends as a way in which they are ‘paid back’ and thus are able to take money off the table. In reality, though, dividends are much like checks cut from the value of the stock – they are subtracted from the worth of your shares. Moreover, they can be a tax burden – in most countries, they are taxed a person’s normal income tax rate. In the US, for instance, this means paying more in tax than one would when simply selling a long-term stock holding in a taxable account. If someone investing in, say, low-dividend growth stocks via a broad index wants to sell, their gains might be 0% or 15% at current rates, vs. 25% or more they may be taxed on dividends. In short: selling stocks can be more efficient, so if you need a steady cash flow from your investments, you could simply sell as needed.

So what is an investor seeking safety in volatile markets to do, if dividends do not provide a secret safe haven from stock storms? Like it or not, reward comes from risk, so avoiding risk may mean sacrificing some reward. A truly safety-oriented investor needs to consider savings accounts, CDs and bonds if they want to reduce volatility and have downside protection for times when equities invariably tank. Beware, though, as bonds may not be quite this lucky next decade – still, they are priced where they are now for a reason: people are still looking for that safe refuge in an uncertain world. There are few free lunches – sticking to not-really-that-safe dividend-paying stocks is not one of them.

For more on this subject, the Canadian Couch Potato has a great series on dividend myths which cover things in greater detail – Debunking Dividend Myths: Part 1 covers some of the most obvious aspects (such as: dividends result in a drop in share price, then: Dividend Myth #2: Dividend investors are successful because they select excellent companies and buy them when they are attractively priced. Dividend Myth #3: Dividend-paying stocks are a substitute for bonds in an income-oriented portfolio. Dividend Myth #4: You can beat the market with common sense: just focus on blue-chip companies with a competitive advantage and a history of paying dividends. Dividend Myth #5: It’s easy to build a well diversified portfolio of Canadian dividend stocks.

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