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Chasing Dividend Yield for Income: Three Reasons to Be Wary

by Rod Greenshields

Financial advisors use a variety of investment strategies to replace retiree employment salaries or business income.

These include bond ladders, systematic withdrawal programs (SWPs), guaranteed minimum withdrawal benefit (GMWB) products, and even strategies in the relatively new category of target payout funds. But one of the most common approaches is the dividend yield strategy.

Relying on dividends for income is a strategy that has served investors well in the past. Who hasn’t heard of the proverbial elderly widow living off the steady stream of General Electric (GE) dividend checks? And many investors believe that high-dividend-paying stocks are preferable to low- or non-dividend-paying stocks for portfolios intended to meet income needs.

The dividend yield strategy has been so attractive because it professes to meet the “golden three” outcomes for retirement-oriented investing—income, capital preservation/growth and liquidity. But as markets have evolved and the retirement investing landscape has shifted, is there anything about this strategy that should concern investors?

Reason #1: There’s No Free Lunch

It’s not hard to see why investors are attracted to the idea of high-dividend-paying stocks. On the surface, these investments seem to offer the best of both worlds: the potential for long-term capital appreciation and a steady income stream. But this perception rests on a fundamental misunderstanding of how dividends work.

Dividends come from profits that a company distributes to shareholders. Faced with a choice between re-investing this surplus into business projects, repurchasing their own stock, or paying it out to shareholders, dividend-paying companies emphasize the last option.

Paying out a dividend means a company has less capital to fund new or existing opportunities (assuming they don’t raise capital through issuing additional equity). Consequently, this is likely to dampen future business growth. All else being equal, when companies declare a dividend, their inherent value immediately declines by the amount of the distribution on the dividend record date. That’s a clear sign dividends aren’t free.

Dividend Yield Versus Total Return

A different approach to framing the income replacement issue is through the lens of total return—the sum of both dividends and capital appreciation. According to this perspective, dividends aren’t necessary in order to receive money from a portfolio. If a shareholder needs income, they can manufacture their own “dividends” at any time by selling shares of stocks or mutual funds.

In 1958, Franco Modigliani and Merton Miller published a seminal paper on capital structure and dividend theory (“The Cost of Capital, Corporation Finance and the Theory of Investment,” American Economic Review, June 1958). Their assessment of optimal capital structures argues that companies should be indifferent to how they raise capital (whether through issuing more debt, selling stock, or issuing new stock) and that dividend policy doesn’t affect the value of a firm.

Most individual investors, however, don’t consider capital structure when evaluating high-dividend-paying stocks. Rather, they make their decisions according to more tangible criteria. And dividends are attractive because they create a mental accounting framework that is more psychologically tolerable. The rules of this game are simple: Spend the dividend check, and leave the rest alone.

Do Dividends Signal a Better Investment Opportunity?

Some might argue that dividend-paying stocks are more attractive investments and that when a company pays a dividend it signals something about its future prospects. For example, it could mean they’re more confident in their future earnings.

At Russell, we’ve conducted our own research and reviewed that of others, but we haven’t found a compelling investment case for this view that dividend-paying companies are better long-term investment opportunities. At best, there’s modest support for the view that some companies that increase their dividends over time may have better future prospects. But we think this is more appropriately left as an investment management decision rather than an income management decision. Be careful of letting a convenient quarterly payment accidentally drive an active management strategy.

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Reason #2: Dividends Have Been Declining

A few decades ago, it was reasonable to invest in a broadly diversified pool of stocks and still earn a healthy dividend. From 1979–1985, the average yield for the Russell 1000 index exceeded 5.5% (Figure 1).

Since then, however, dividend yields have dropped significantly. The lowest range was during 1998–2002, the tech bubble period, with an average of less than 1.5%.

The most recent 2003–2010 range does, however, show a modest bump in dividends. But two factors likely drove this change. First, the Jobs and Growth Tax Relief Reconciliation Act of 2003 equalized the earlier income tax penalty for dividends. Second, 2009 marked the highest average dividend yield since 1995, at 2.96%. But this may have been the temporary effect of companies having limited re-investment opportunities in the midst of a broad recession. To that point, the average dividend yield already declined to 2.23% in 2010.

Relying on dividends to provide a level—and large enough—income isn’t as easy as it used to be. And while it’s difficult to predict the exact dividend policies companies will adopt in the coming years, it’s unlikely that they will be as high or as stable as they have been in previous decades.

Reason #3: Concentration Risk Is Common

In order to achieve a dividend yield level even close to what a broadly diversified investor would have received a few decades ago, an investor would need to concentrate their portfolio into no more than the highest 10% of dividend-paying stocks, as represented by the Russell 1000 index (Table 1). (Keep in mind that indexes are unmanaged and cannot be invested in directly.)

Index/Stocks Yield
(%)
Russell 1000 index ( 1979–1985) 5.6
Russell 1000 index ( 2010) 2.2
Top 100 Russell 1000 index dividend-yielding stocks ( 2010) 5.1

Note that at present, 71 of these 100 top-yielding securities in the Russell 1000 are in the financial services and utility sectors. Pursuing this strategy would allocate nearly three-quarters of an investor’s stock portfolio to two narrow sectors. And as history has proven time and again, unexpected events can devastate narrow areas of the market and individual securities. For example, it’s an understatement to say that the financial sector has experienced a bumpy ride the past couple of years. And the June 17, 2010, announcement by BP p.l.c. (BP) that they would suspend their dividend payments was unwelcome news to many shareholders.

Lastly, don’t forget that dividend yield is defined as a company’s dividend payments divided by its share price. A high dividend yield might not equal a high dividend payment; it could result from the plummeting share price of a troubled company.

A Lesson Learned Too Well?

One of the more perplexing questions about the dividend yield approach is why dividends were so popular before the 2003 tax changes equalized their tax treatment. (Before the Tax Relief Act of 2003, dividends were taxed at ordinary income rates. After the act, their effective tax rate became the same as the capital gains rate, with a maximum of 15%.) It suggests that strong psychological or emotional factors are at work. If dividends can be considered a zero-sum game, or a worse choice in historical tax environments, then why has dividend yield investing been so attractive in the past?

Much of the attraction undoubtedly stems from the classic wisdom voiced by experts, family and friends: Never invade principal. This tenet of responsible investing is ingrained so deeply and so effectively, it’s difficult to dispel. For many wealthy individuals, it’s a core belief that helped them create their wealth in the first place. Manufacturing dividends feels like robbing the nest egg; harvesting company profits a bit at a time does not. And so emotion trumps theoretical investment rationale.

In Defense of Total Return

As more investors enter retirement and need to replace substantial proportions of their income by using their investment portfolios, a dividend yield strategy is likely to fall short. There may simply be no alternative to adopting some form of total return investing. Even more worrisome for the never-invade-principal adherents: The time may come when prudently drawing down a portfolio becomes necessary to fund living expenses.

When we consider the risks of a dividend yield strategy discussed above, a total return approach that relies on a combination of dividends and capital gains to fund income-replacement needs is compelling.

Rod Greenshields is consulting director of U.S. Private Client Services at Russell Investments.


Discussion

Brian from TX posted over 3 years ago:

Assuming stock price appreciation is automatic by internal "beneficial'' company use of retained earnings rather than paying dividends is too simplistic.


Shoshana from MI posted over 3 years ago:

Thank you. I found it very educating and quite compelling


J from TX posted over 3 years ago:

However, dividends are a major source of return when the market is going sideways or down. They also offer some protection.


Larry from IL posted over 3 years ago:

very informative thank you.


Thomas from TN posted over 3 years ago:

Over the long term, isn't the majority of stock return due to dividends AND the reinvestment of dividends?


Mike from NC posted over 3 years ago:

The more I read from so-called "expert analysts", the more I am convinced they are almost all just guessing...and guessing poorly at least half the time!!


Scott from MT posted over 3 years ago:

Total return strategy relies on your having all your wits. Dividend income has a better chance of sustaining those who are less able to make tough analytical decisions.


Robert from FL posted over 3 years ago:

Your article, for the most part, is simply wrong. If one holds the stock of a company which consistantly raises its dividends over many years price appreciation will necessarily take place or the yields would become astronomical... the market will correct this by increasing the share price.

42 such companies make up the S&P 500 Dividend Aristocrats: companies which have increased their dividends for at least 25 years.

Among these are firms like ABT, ADM, AFL, BDX, CB, EMR, JNJ, KO, MCD, MMM, PG, VFC, and XOM.

Of course buying these Blue Chips does not mean you forego capital appreciation. Nor does it mean that at some point you cannot annuitize all or part of the total or "self annuitize" the portfolio. This is simply done by taking a mortality table and adding 20 years to your predicted life expectancy. (If you are4 65 you may expect to live to about 85, so adding 20 years means you figure on spending the last dollar in this portfolio at age 105. Next make reasonable estimates of portfolio growth and inflation, and plug the numbers into a retirement calculator such as My Calculator.

Prudently selling overvalued stocks as you go, making consideration for taxes, while maintaining your asset allocation, you will be able to collect an amazing amount of money.


Robert from FL posted over 3 years ago:

Using the above method, let me make a hypothetical example.

Age 65; years to retirement 0;
Portfolio value, $500,000
Length of retirement, 40 years.
Annual portfoli8o increase 7%; inflation 3%.

Annual payment $24,000 in 2011 dollars
Final (40th) payment in 2050, $75,700
Total payout, $1,801,895

If you figure a 30 year retirement (to age 95) then your first annual payment would be about $27,450, and subsequent payments would be the same amount in 2011 dollars, corrected for inflation.

Plug in your own numbers at MyCalculator.com

Point 1 "There's no free lunch" You are the owner of companies who are good stewards of your property. Rather than spend earnings on executive bonuses and marginal investments, they deliver to their owners on the average 50% of their free cash flow.

Point 2 "Dividends Have Been Declining" Certainly not true for these comapnies, and a large number of other companies with shorter than 25 years, such as "Dividend Achievers". Simply do not buy companies with many years of dividend increases.

Point 3 "Concentration Risk"
That's pure BS. Do these choices look like financial stocks? ABT, ADM, AFL, BDX, CB, EMR, JNJ, KO, MCD, MMM, PG, VFC, XOM. Only AFL and CB fall into that catagory as Insurance Stocks. If you decide to go outside the 42 "Aristocrats" and add some stocks with 'only' 10 years of increasing dividends you can add the "Dividend Achievers" which 1s almost an other 200 companies from all sectors.

I maintain a well balanced portfolio of dividend growth stocksa all with a current yield of 3% or higher, and an average yield much higher.


Jim from CA posted over 3 years ago:

When looking for income I usually buy JNK, HYG or PFF ETFs. These typically yield 7-9%.
They have tended to also increase in price as
their dividends decreased. It's easy entry and easy exit.


D from IN posted over 3 years ago:

The true gems are stocks such as FDS which have a record of monotonously increasing both earnings and dividends. The catch is that the yield is low and you would have to wit some years to get a decent yield on your initial investment.


Gareth from MN posted over 3 years ago:

I'm not sure why Robert from Florida would say, "Your article, for the most part, is simply wrong." He then goes on to demonstrate using both dividends and capital appreciation to fund retirement, essentially in line with the author's conclusion, "When we consider the risks of a dividend yield strategy discussed above, a total return approach that relies on a combination of dividends and capital gains to fund income-replacement needs is compelling."

I would conclude more strongly than the author that at the end of the day, Total Returns are all that matters. Sure it is nice to have a dividend stream, and the companies that provide consistently increasing dividends tend to be the best run and more profitable.

So I leave you with the question. Would one prefer Robert in Florida's Abbott (ABT) that over the past 5 years has returned 28% including dividends of $7.47 AND capital appreciation, or a stock like Dolby (DLB) or DG FastChannel (DGIT) which pay no dividends but returned 5-year capital appreciation of 115% and 456% respectively? I only chose these companies to make a point. Others would show different results.

Disclosure: I am long ABT, DLB, and DGIT.


Douglas from OK posted over 3 years ago:

It might depend on which dividend yield criteria is used. If you apply the Weiss dividend yield philosophy you use the high yield as the buy trigger when the other criteria are also met. This results in buy/sell targets that provide approximate capital appreciation on the order of 8-9% with a dividend yield in the order of 2-3 % over the last 20 years (combined about 11%). Well done Robert I think you helped me more than the article did.


E from GA posted over 3 years ago:

Apparently Russ is not looking any further than his own nose or perhalps his pocket book. To date I havn't found an advisor or a growth MF for my Small growth port. that can match the total return of my Dividend port. that I manage with limited time. Use advisors only on a pay for performance agreement.


Brian from FL posted over 3 years ago:

An excellent article. I have drawn from it for use in my MBA Corporate Finance class at the University of Florida. There is a lot in this short article that is not covered in textbook treatments of dividend policy.


jan from WA posted over 3 years ago:

This article is really saying don't concentrate ALL of your portfolio in high-dividend equities. What I do personally is put 5% of my portfolio in a dividend-capture fund that pays out monthly. I treat it as sort of money-market account, much better than CDs at banks. The fund itself doesn't move at all, beta 0.29 I calculated. If I am really concerned the fund go bust, I buy a put option on it. Remember, only 5% of my portfolio is this strategy.


Courtland from CA posted over 3 years ago:

I disagree about dividends.Over the years they have provided approxximately 40 percent of total return. Also dividend paying stocks historically have outproduced non dividend paying stocks.


George from NC posted over 3 years ago:

The comments provided were as valuable as the article. Thanks to all who contribute.
I put around 7% of my retirement fund in high dividend paying energy Trusts and Limited Partnerships, such as ONEOK.


Andy from CA posted over 3 years ago:

The fundamental premise of this article has to be questioned. Yes, yields have declined as a whole but no rational income investor would hold an equity with declining payment. The author provides very little information on what is high yield. Seocond, he seems to overlook a very basic concept namely, yield on cost. He further seems to have based his thinking on a "buy and hold" premise, which again, does not make sense.
Such articles make me wonder what sort of selection criteria were used.


Charles from CO posted over 3 years ago:

I also disagree about dividends. It is true that yeilds have decreased, but that doesn't necessary mean the dividend has decreased. I have held XOM for 60yrs. I only recall increases in dividends. The XOM payout is less now than in the past, but of course the price is much higher than in past so the dividend has not decreased.


Walter from PA posted over 3 years ago:

As retiree for some 15 years, I have found that a combination of a cost efficient muni bond fund via Vanguard, two hy bond funds and foreign bond exposure, high dividend paying stocks and mutual funds have allowed me to not only derive sufficient income but to grow my porfolio from the surplus and reinvesting that I have been able to do. If a particular stock or fund begins to faulter, I move on to another investment or increase monies from its sale to one I already have. This does mean frequent monitoring, but my portfolio is greater now that it was during the crash of 2008, and my income as grown dramatically as well. Good luck with your own approach.


Ron from TX posted over 3 years ago:

I have a good living from my D&I (110K)/yr. You have to do your due diligence in buy and trading these stocks. I average a 5.6% yield and all my divident stocks. Last year I made over 100K just buying and selling and rebuying these stocks. If you will spend just a little time and research you can do it too.


Robert from IL posted over 3 years ago:

OK, so you have done a good job explaining what is not a good idea. But what is a good idea for income? Are there any good ideas about income replacement that involves dividends? Perhaps your knowledge base says no! This could mean that your knowledge base is deficient. See "Dividend Growth Investing" which is a book on how to choose dividends that avoid all of the "badies" in your article.


Stephen from FL posted over 3 years ago:

Stock dividends are part of overall investment risk, i.e.reduction or elimination...monitor the payout/per share earnings ratio and determine what rate is acceptable for individual tolerance...This approach has worked for our family for years...


Conrad from WI posted over 2 years ago:

A $50 stock pays a 3% dividend today. If the share value drops to $25 tomorrow, the dividend increases to 6%. The stock has lost
half its value, but the dividend looks great.
There are many examples of this abounding. I am not impressed with this math providing income!


Don from TX posted over 2 years ago:

I agree with David. There are several studies that contradict the Russell attitude. In addition you have restricted yourself to the U.S. Since we are global take a look at global stocks where dividends are more "normal". In a decade of negative returns and bleak prospects give me stocks with dividends and appropriate diversification.


Henry from VA posted over 2 years ago:

Vanguard Dividend Growth VDIGX managed to survive the recession better than most, and it has maintained a relatively small allocation to finance companies the past few years. Only 47 high quality stocks at present. Current SEC Dividend 2.27. Aims for dividend growwh plus some appreciation. As one a couple years from retirement, I am likely to move more of my stock portfolio to this fund over the next few years.


Paul from MD posted over 2 years ago:

I have read several reports that take the opposite approach. Dividends are a sign of strength as long as they are a minor part of a company's profits. If the stock market is static or falling, dividends may well be the only bright light for investors.


Clifford from PA posted over 2 years ago:

Good article.


Stephen Smith from MI posted about 1 year ago:

The best part of this article was understand the business you are investing in.
I have 3 classes of investments:
1. Dividends
2. Growth
3. Cash

With the fisical Cliff comming I now have more in Cash than ever.

Also good hospitalization coverage will protect your portfolio.
I have a high deductible plan with an underlying supplement funded with cash.

I don't need to touch the dividend or growth buckets for about 10 years


Mark Race from OH posted about 1 year ago:

WebMaster, How about updating the comments to this article? Comments that are a year old are for the most part no longer relevant.


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