Dividend investing vs total return investing

Let’s take a look at what dividends actually are.

A company has earnings.

It then distributes some of those earnings to investors either as dividends or through share buyback and retains the rest to grow the business. The same company with the same earnings can distribute all or none or any other amount of earnings as dividends, and it will make no difference to your total return how much is distributed.

For international (non-Australian) shares, companies often distribute a portion of earnings in the form of a share buyback to boost up the price as a more tax-efficient way to distribute profits.
For example, let’s say there are currently 10 shares valued at $8 each and the company decides to distribute $16 of earnings back to investors – they buy back 2 shares, and now there are 8 shares at $10 each, so the value of each of your shares have increased $2 as a way for the company to distribute the $2 instead of paying it out as cash dividends.

The more they pay out in dividends, the less that is retained to grow the business, and therefore you should expect growth to be reduced by a similar amount to what is paid out in dividends. Dividends are not free money — they come out of the total return. You can even see it happen in real-time when companies/funds go ex-dividend and the share price drops by the amount of the dividend being paid out. As a result, if you go with high dividend funds, since you’re getting lower growth (remember, total return is reduced by the dividends paid out), then if you don’t re-invest the excess, over time, your capital will lose ground faster due to eating away at more of it.

On top of this, by restricting yourself to only the small subset of companies that have high yielding shares, you face concentration risk through lack of diversification. Many Australians opt for a high proportion of Australian shares for their high yield, but the Australian market is highly concentrated with half the index in just 10 companies and 2 sectors. If there is an isolated economic downturn, or either of those two sectors has a downturn, your whole portfolio is going to suffer. Compare that to a globally diversified index fund holding securities across 46 countries and with no more than 13% in its largest weighted 10 companies combined and no more than 2.4% in any one company and you can see the risk of concentrating your shares based on yield.

Those who cite the performance of a subset of dividend stocks to “prove” the success of dividend investing use backwards-looking data throwing out all the companies that intended to increase their dividend over time but failed, falsely giving higher looking returns than using unbiased data. This is known as survivorship bias. You can’t know in advance which companies will successfully increase their dividends into the future. Dividend Aristocrats are a list of US companies that have grown their dividends for 25 consecutive years or more. From that Wikipedia link, you can see that in 2009 the list declined from 52 to 43 companies, and the following year, a further 10 companies were dropped from the list.

The list of problems with dividend investing begins with a misunderstanding of what dividends are – generally mistaking them for earnings – and then continues to confirm the fallacy with biases, leaving you exposed to risks such as concentration risk, risk of depleting their portfolio too fast, and taking more market risk by believing high dividend stocks are a bond proxy and is safer than it really is.

The solution is to focus instead on the total return of the investment and draw a percentage of assets that has the highest chance of succeeding over the time frame you need and ideally adjust your spending a little in market down years. There has been a lot of research done in the US, and they came up with the 4% rule to last 30 years having a very high chance of success (95% with a 50/50 portfolio, including going through wars, hyperinflation, recessions, depression, etc.). For an early retiree wanting to last around 50 years, it’s around 3.25%.

You can have higher numbers if you’re willing and able to cut back during poor economic periods, take on a part-time job, have fewer holidays, and so on. So, once you have your withdrawal rate, if your dividends return more than that, re-invest the excess, and if they return less than that, just sell down what is needed to get the required amount.

Essentially, dividends are not like rent. Earnings are closer to rent, and dividends are arbitrary, and you should be wary of relying on something so arbitrary for your financial future.

Further reading