The following is a guest post from Matt Becker, founder of Mom and Dad Money. Matt is a proud father and husband, and his site is dedicated to helping new parents build financial security for their family.
Although Matt and I have somewhat different personal opinions in regards to dividend strategies, I thought it might be fun to invite him to take the stage and share his perspective on why he thinks Total Return Investing would be better. I’ve always maintained the message on My Money Design that there is more than one way to reach financial freedom. If you can keep an open mind and not reject something just because it is different than what you use, then maybe you might just learn something.
Go ahead Matt ….
If you have paid any attention to the investment world since 2008, you have undoubtedly heard of dividend investing. A dividend investing strategy is simply one in which an investor chooses to put his or her money in stocks that have a strong history of paying consistent dividends.
An alternative to a dividend strategy is called total return investing. With a total return approach, an investor is looking for returns from any source, including but not limited to dividends. Specific to stocks, this essentially means that an investor will view capital gains as an equally appealing source of returns and will proceed with the sole goal of maximizing returns for a given level of risk, without preference as to where those returns are coming from.
It is my view that a total return strategy is superior to a dividend approach in several ways.
Some Investing Terminology:
A dividend is a dollar amount paid to shareholders out of the company’s earnings. It is typically paid on a regular schedule.
Capital gains represent the difference between a stock’s purchase price and its sale price. So if you own one share of stock that you purchased for $1 and you sell it for $2, you would have a $1 capital gain. You can also have a capital loss if you sell for less than your purchase price.
When a dividend is paid, the value of the company drops by the amount of the dividend. So if a single share worth $10 pays out a dividend of $1, that share will then be worth $9. So while you receive immediate income in the form of a dividend, your potential for future capital gains is decreased.
A Case for Total Return Investing:
Where Have Stock Market Returns Historically Come From?
According to John Bogle in The Little Book of Common Sense Investing (Exhibit 7.1), over the past 100 years capital gains (represented in his numbers by earnings growth) have accounted for:
- 53% of stock market returns while
- dividends have accounted for 47%.
But over the past 25 years:
- 65% of returns have come from capital gains
- while only 35% have come from dividends.
Not only that, but the actual return from dividends has fallen, from 4.5% per year over the past 100 years to 3.4% per year over the past 25. Today, the overall US stock market has a 2% dividend yield.
Looking at these numbers, it becomes pretty clear that capital gains account for at least half of the returns that the stock market produces, but the trend is such that it’s closer to 2/3 of the returns over more recent history. Given these facts, understand that if you choose to focus on dividends rather than a mix of dividends and capital gains, you’re doing something similar to choosing to invest in bonds over stocks. There’s nothing inherently wrong with the decision, but you are limiting your long-term growth by focusing on a market sector that has historically produced smaller returns.
With a total return approach, you expose yourself to both dividends and capital gains. The increased diversity in source of return, along with an increased exposure to the higher-returning source, both serve to increase your chances for long-term growth.
The Importance of Diversification:
The importance of diversification cannot be overstated. It’s been said so many times over the years that it’s become a cliche, but it couldn’t be more true that diversification is the only free lunch in investing.
Very simply, the premise of diversification stems from the fact that we do not know where future returns will come from. We don’t know whether dividend paying stocks will outperform their growth-oriented peers, whether large stocks will outperform small stocks, or whether the healthcare industry is truly the place to invest for the future. But when we are properly diversified, we don’t have to know. We are exposed to everything, so assuming that there is growth somewhere, we will be in on the action. It is the single investment tool in your arsenal that allows you to decrease risk without sacrificing expected return.
With a total return approach, you can go all-in on diversification. Because you don’t have a preference for your source of returns, you are free to invest in any type of company you want. But with a dividend approach, you are by definition limited in your choices. Sure you can choose companies across different industries and different regions of the world, but the reality is that companies with a strong history of paying dividends all share certain characteristics. And there are many types of companies that you will never have exposure to because of your self-imposed limitations.
Total return investing maximizes your opportunity to use the most powerful investment tool available to you.
A Risk Story:
Among the most widely held reasons for pursuing a dividend investing approach is the appeal of decreasing investment risk. Intuitively it makes sense that stable companies that pay out a high percentage of earnings as dividends will have less volatility than companies who are keeping their cash internal and providing less immediate income to their owners. And over the last few years at least, this has proven to be true.
However, this approach to mitigating risk ignores the fact that your investment portfolio does not have to consist only of stocks. A good total return approach will use stocks as the main driver of long-term returns, with portfolio risk managed by the inclusion of other types of investments. By including assets in your portfolio that should behave differently than stocks, such as US Treasury bonds, you can achieve your desired risk tolerance without sacrificing the benefits of diversification.
It is important to view your your investment portfolio as a sum of many parts. Looking at any individual piece in isolation skews the purpose of that piece as part of the larger whole. Maximizing the particular purpose of each asset type, and diversifying across asset types with a proper asset allocation, is a more efficient and holistic approach to investment risk management.
The Impact of Taxes:
If you are investing only within tax-advantaged retirement accounts, then the question of tax efficiency is moot. But many investors are putting money away with the goal of early financial freedom, and that will likely necessitate the use of taxable accounts for a portion of your investments. In that case, the tax characteristics of your returns matter a great deal.
In this area, capital gains are more appealing than dividends. Dividends are taxed year after year, slowly eating away at your returns. Capital gains will likely be taxed eventually, but you have the ability to defer those taxes and use that saved money to earn you more in the meantime.
To illustrate this point, I created a simple example in a Google Spreadsheet that you can view here: Dividends vs. Total Return in Taxable. I made some assumptions, which are very transparent in the worksheet, to compare the after-tax result of each strategy over a 30 year time period. Because of the power of tax deferral the total return strategy comes out ahead. If you increase either the investor’s starting balance or annual contribution, which are both set rather arbitrarily in the example, the difference will be even greater.
All Hail the Dividend Aristocrats?
One of the biggest arguments that I’ve seen in favor of dividend investing over a total return approach is the recent performance of the so-called dividend aristocrats. A “dividend aristocrat” is simply a company that has raised its dividends for at least 25 consecutive years. Certainly an impressive feat.
Many of the articles touting these specific stocks cite statistics showing that they’ve outperformed the S&P 500 over some recent time period, anywhere from the last 1-15 years. And they’ve done so while experiencing lower volatility, the primary definition of investment risk. Higher return for less risk. Sounds pretty great right?
As soon as you hear an argument like that, you should immediately have serious doubts. Risk and return are inextricably linked, and you just cannot decrease risk without decreasing expected returns unless you’re talking about simple diversification. But beyond that, do you know what else has had similar returns to the S&P 500 over recent time periods, and at much lower volatility than even the dividend aristocrats? Bonds. Simple, boring bonds.
The above chart, taken from Morningstar, shows the growth of $10,000 in two different funds over the past 15 years (5/30/1998-6/3/2013). The blue line represents an investment in Vanguard’s S&P 500 index fund (VFINX). The yellow line represents an investment in Vanguard’s Total Bond index fund (VBFMX). Very clearly, the bond fund has outperformed with much lower volatility.
The point here is that while a particular strategy might have worked over some arbitrary time period, that doesn’t make it a better long-term approach. Bonds certainly have a place in your portfolio, but should they completely replace stocks? I think most people would say no. And by that same logic, a dividend strategy shouldn’t replace a total return approach simply because of strong recent performance.
One last point on these dividend aristocrats. These are not magical companies whose performance never falters. Just like other companies, their fortunes can change. As a case in point, in 2009 there were 52 stocks that met the group’s strict criteria. As of 2012, there were 51. But of those 51, 13 were different than the original set. So over the course of just 3 years, there was a 27% change in the group’s composition. As always in investing, past performance is no guarantee of future returns.
How To Implement a Total Return Approach:
The simplest, and in my opinion the best, way to implement a total return approach is to use total market index funds. Investing in a fund that represents the entire US stock market will expose you to the entire range of risk and return that the market has to offer. You can do the same with international stock markets and with the bond and real estate markets.
But you don’t have to use index funds. If you like picking stocks, a total return approach simply expands the universe of stocks from which you can make your selections. If you have genuine stock picking skill, then the increase in choices should give you greater opportunity to allow that skill to benefit you.
Whether you’re investing for long-term growth or you’re relying on your investments to provide today’s income, your goal is simply to have the money available to meet your needs. No rational investor should have a preference for the source of this money. Whether it comes from interest, dividends or capital gains is immaterial. What matters is that you achieve the desired level of income and/or growth at a reasonable level of risk.
While there are many ways to achieve this, it’s my belief that total return investing is the most efficient approach. It has the advantages of diversification across companies, diversification across sources of return, and tax efficiency. It takes full advantage of all market forces in play, while still allowing you to control overall risk through proper asset allocation.