Dividend Investing – Why I refuse to join the craze
Walk into any financial advisors office, and one of the first things they’ll do is sit you down to talk about your goals. “When do you want to retire”, “How much money do you think you’ll need”, “What’s your risk appetite” (though that last one is a downright stupid question. Here’s why.) It’s safe to say that for every financial situation, there is a different, and appropriate, investment strategy. However, what I’ve noticed just through combing through finance blogs is that there seems to be this “Holy Grail” mentality over dividend investing that’s erupted over the last couple years.
Seriously, people are treating it like the Hand of Midas or a hooker with 3 tits.
Which to some degree, I get. Dividends are very easy to understand, the math is very logical, they seem “low risk”, and they generate income without anyone having to get off their fat asses and actually do something (which is my kind of investing). But I don’t think that dividend investing is necessarily the end all, be all when it comes to investment. And I think it’s a PARTICULARLY stupid idea for millennials to try to generate income through dividends, at least this early in the game.
Sit tight kiddo’s, I’m going to piss some people off. But hey, it should be fun!
Dividend Investing – What exactly is it?
Before I go off on my rant, we have to make sure we understand the vocabulary that’s being used, and what exactly it means. Here’s what you need to know
- Dividends – A dividend is a cash payment made to shareholders for being… well, shareholders. Essentially, a company will make a payment 4 times a year to those who hold their stock. Why? Well, after accounting for a lot of costs, any good business is going to have money left over. That can either go back into the company as investment, or be paid out to the shareholders (owners) of the business.
- Dividend Ratio – Dividend payment / share price. This is just one way that investors compare two different shares of stock when discussing dividends.
- Dividend Growth Rate – This is how quickly a company decides to grow their dividend year over year. For example, if Apple grew it’s dividend from $2.00 to $2.10 over the course of a year, then it’s dividend growth rate would be 5%.
- Dividend Aristocrats – These are the Big Swinging Dicks of the dividend world. To be a member (HA!) of the dividend aristocrats, a company must have increased their dividend payment every year for 25 years. Which is essentially like saying, “We’re going to increase our dividend payment every year indefinitely.” If I told you I had an investment that was going to make MORE money every year, would you take it? Yeah, I thought so.
Alright, that’s all the vocabulary lesson I’m going to give you for now. I can already see some of you falling asleep.
Let’s move on to why everyone thinks that dividend growth investing is the bomb.com, and why I refuse to subscribe to that line of thought.
Argument #1 – Dividend Investing provides for passive income.
Oh yeah, the good ol’ P.I. argument. Passive income is what makes financial bloggers the world around cream their pants and moan in passionate agony. After all, the only thing better than making money is making money and not spending any time doing it, right?
And to some degree, they’re right: Dividend investing really doesn’t take that much time on the part of the investor. After all, you take that money, put it towards some Dividend Aristocrats, and sit while your “checks” roll in (though if you have any intelligence you reinvest those dividends).
But here’s what I need to know: is there something ELSE you could be doing with that money that provides for a better yield?
I mean, even if you had $10,000, and invested in the highest yielding Dividend Aristocrat, you’d still only make 5% on that money, which would be $500. And yeah, you didn’t have to spend any time or brainpower investing that money. After all, anyone can get an online brokerage account and click “buy”.
But don’t you think there are other passive income opportunities out there, ones where you could spend $10,000 and get MORE than $500? Blogging, freelancing, retail arbitrage, selling on Amazon, writing an ebook, and a plethora of other activities could almost certainly gain you more than $500 in a year, with a $10,000 investment.
So, surprise surprise, that’s exactly what I think. And if you’re on this page, you’re part of that experiment. GOTCHA! So before you start dropping lots of money on dividend paying stocks, be sure to ask yourself if there’s anything else you could be doing with those funds.
Argument #2 – Dividends account for half of the return of the SP 500!
OK, so if you’ve spent enough time reading about how great dividend investing is, then you’ve come across this statistic. And I’m sure that those that are saying it have a decent enough background to think they’re doing the math correctly. For now, let’s just assume that it’s true.
But does this necessarily mean that if you invested in stocks that DIDN’T pay dividends, that you only made half of the return of the stock market? Ehhh, not so much…
In fact, small capitalization stocks (those that are considered “small” companies that grow incredibly quickly) returned 14.4% over the course of the last 80 years, as opposed to those large cap stocks (those that tend to pay dividends). They only grew 11.2%.
So while dividends are great and seem to account for a healthy chunk of the return on the SP 500, that doesn’t necessarily mean that you should rely on them to maximize return. Remember, the younger you are, the more risk you should be taking, which means small cap stocks are going to fill you up with risk you need to get the returns you deserve.
Argument #3 – There are lots of Dividend Aristocrats, which means I can be well diversified.
The word “diversification” can be extremely misleading. Everyone throws around the phrase, “Don’t put all your eggs in one basket” and thinks that they have a firm understanding of the method of diversification. To some degree it’s correct, but to some degree it’s not. Hold onto your panties, cuz we’re about to get math-y up in here.
Diversification benefits are derived from the fact that not all stocks move in the same direction. This is a mathematical benefit, not a “logical” one per say. This mathematical representation of diversification is captured in what’s called the “covariance”. This is just a statisticians scary way of asking, “When one asset moves, does the other asset move as well? If so, to what degree and how often?”
And while for the most part, you can assume that two assets that are in different industries will have a lower covariance than two assets that are in the same industry, you can’t just assume that that’s the way it is all the time. There might be some factor that connects them both. Maybe two CEO’s both have debt service from the same bank. Maybe two companies that are seemingly unrelated are both trying to gain access to a new market and are being refused by local governments.
There are many ways that two companies that don’t seem related could be. And while that’s not captured in a quick glance over a 10-k or an article in Yahoo Finance, it DOES get captured by the covariance.
And until I see this formula from someone giving me the argument for diversification benefits inherent in dividend investing…
Argument #4 – Dividend investing allows for higher returns with lower risk because I get a cash payment.
There has been 1 (maybe 2) ways that have been confirmed to reduce risk and maintain the same level of expected return. That method is simply called diversification. If you’re adding higher level returns, then you have to be adding a higher level of risk.
80 years ago if you found a way to increase returns without adding risk, then I might have believed you. After all, markets were much less efficient back then. But considering we now live in a world where a trade can take place in a matter of nanoseconds, and there are WAY more people invested in the stock market now, markets are way much more efficient now.
So I subscribe to the fact that IF someone with an extra couple thousand dollars to invest in dividend stocks is getting a higher return than someone else, it must be because they are taking on more risk. Most people don’t have the infrastructure to produce alpha, and even if they did, it would be incredibly hard.
Not that I think more risk for more reward is a bad thing. But the returns aren’t as high as everyone is making them out to be, and I don’t think that even if they were that they’d be a “better deal” when it comes to risk.
Argument #5 – Dividend investing has an inherent compound growth rate which means dividends should continue to grow.
This makes sense. Growth rates are where you’re going to find some serious increases in returns. However, there is a very simple formula to account for growth rate while pricing a stock:
P equals price, D is the dividend payment, r is the required rate of return on the part of the investor, and g is the growth rate. This is the second formula I ever learned in my intro to finance course. The first one was this:
Why am I giving you a super simple formula? Because here’s what you need to know: If every finance student learns this in the first two weeks of their course, then pretty much everyone who is in finance should know this formula. And if everyone knows this formula, than growth rates have already been calculated into price. Meaning that Joe Shmoe Blogger (myself included) is not going to find any sort of alpha with this formula; it’s already been priced into the market.
So please don’t think that finding a stock with a high dividend growth rate is going to unlock some higher risk-adjusted returns. There’s just no way that you’ve found some way to produce higher returns that someone else hasn’t already.
Sorry boo boo. Good try though!
Argument #6 – If I get dividends, I can choose to reinvest them into the company.
I don’t here this argument about dividend investing as much as the others, but this one gives me a the most epic sad face you’ve ever seen. Here it is:
The reason this makes me so sad is because it demonstrates a fundamental misunderstanding about how the stock market works.
Ladies and Gentlemen: When you buy a stock, you’re NOT giving the money to the company. Spending $700 on one share of Apple does NOT mean that you’re giving the company $700. It means that you’re giving some other random shareholder $700. Apple in no way shape or form directly benefits from this sort of transaction.
UNLESS your argument involves the fact that an increase in market buying of the stock increases the market capitalization, which therefore increases the price per share, which makes seasoned equity offerings more attractive.
But I’ve only ever read about one blogger who can even make/understand that argument, and he happens to agree with me. 🙂
So when you’re saying that being paid dividends allows you to choose whether or not you re-invest in the company, you’re using flawed logic. Really, it just allows you to buy more shares, which increases the stock price, NOT the amount of money the company has to work with.
Dividend Investing and why I refuse to join the craze – The Wrap Up
I very much consider myself a contrarian. If I see a lot of people are doing something, I’ll generally think that they’re doing something wrong or that any sort of market advantage has already been eaten up by them. Unfortunately, dividend investing is no different for me. Here’s why:
- Yeah, dividends are passive income, but if you’re looking to retire before 80 and want to live on more than SPAM and ice cubes when you’re that age, you need to have a more lucrative business.
- Dividends are a big piece of the SP 500, but you can’t argue that because they make up a chunk that they’re the ONLY way to make real money in the stock market. Not to mention, NO ONE agrees on how to do the math.
- You can’t just assume that because two companies are in different industries that they’re diversified. Diversification is a mathematical principal, NOT necessarily a logical one.
- Any risk-adjusted alpha is eaten up by wall street computers, not you taking 10 hours to read through a 10-k. You will not find a higher return, lower risk situation in the stock market.
- Everyone considers compound growth rate. The freshman finance student at your local community college has already considered growth rate. You’re not the first person to consider growth rate of dividends. It’s already been priced in; move on.
- Reinvested dividends don’t magically find their way back into the hands of management. They find their way back into the hands of shareholders. THIS ISN’T ALWAYS THE SAME THING!!!
I know this post might be controversial, but there’s nothin’ like a little controversy to get a conversation started. So what are YOUR opinions on this matter? Have I completely debunked the myth that millennials should be lining up to buy dividend stocks? Or do you still think it’s a practical way to build up passive income? Let me know below!
Keep trying to crack the code,