The Flaws of a Dividend Investing Strategy

Dividend investing is a popular strategy for many investors who are looking to generate passive income. The idea of receiving regular cash payments from your investments is appealing but the concept of dividend investing is based on a behavioural error where investors incorrectly treat dividends as free money that is disconnected from capital value or share prices - a phenomenon known as the Free Dividend Fallacy (Hartzmark et al., 2018).

The Dividend Disconnect

To begin, it's crucial to have a clear understanding of what dividends truly represent. At its core, dividends reflect the capital allocation decision made by company's management on how to deploy their earnings. They constitute payments made by a company to its shareholders from a portion of its profits, typically disbursed in the form of cash or additional shares of stock. These payments are typically paid regularly, often on quarterly basis.

Dividend investors view this as companies paying out "free money" as an independent source of income, similar to payment from a bond. What they may fail to comprehend is that when companies distribute dividends, the share prices must decrease. This is because the amount paid out in dividends no longer belong to the company and so the value of the company (and its share price) is diminished. The critical point to understand here is that $1 in the pocket of shareholders, received through dividends is worth the same as $1 held by the company itself. Therefore, the fall in share price must match the amount of dividends paid out. This is an inescapable mathematical truth, unless one chooses to disregard mathematics altogether or believes in the improbable notion that capital can miraculously materialise out of thin air. In other words, receiving $1 worth of dividend is no different from selling $1 worth of shares and pocketing the cash proceed. Notwithstanding, day to day fluctuation in share prices may have obfuscated this simple math, leading many investors to disconnect dividends from share prices.

The Problems of Dividend Investing

So, what's the issue with dividend investing even if dividends influence share prices?

One significant issue with dividend investing is that many dividend investors are stock pickers who rely on their ability to choose individual stocks. However, it has been consistently demonstrated that the average retail investor tends to fare poorly in picking stocks. In addition, the focus on dividend-paying companies can lead such investors to become excessively concentrated in particular sectors, such as REITS and banks that pays higher dividends. This concentration exposes them to elevated levels of sector-specific risk.

Another issue is that dividend investors have demonstrated willingness to pay a premium for dividend cashflow, exceeding what a rational investor would, especially during periods of low interest rates. According to the study by Hartzmark et al. (2018), this premium for dividend cashflow can diminish dividend investors' expected return, reducing them by as much as 2% to 4% per year.

Lastly, dividend investors tend to maintain distinct mental accounts for dividend cashflow and share price changes. You probably have encountered dividend investors rationalising holding on to stock with declining price because they continue to receive cash dividends, while hoping for the stock price to rebound. The neglect in share price changes could hinder investors' ability to assess the overall performance of the stock holistically.

Dividend-paying Companies do well, on average, but not because they pay Dividends

Having said that, I want to be abundantly clear that I am not implying dividend-paying companies are necessarily inferior. On the contrary, they often do quite well, on average, compared to the overall stock market. However, their performance has nothing to do with their decisions to pay dividends. Instead, it is largely because many dividend-paying companies tend to be large value companies with strong profitability, i.e. their factor tilts towards value and profitability are driving the returns of dividend stocks. Investors may instead choose to invest in the broader market with similar factor tilts without subjecting themselves to the concentration risk associated with dividend investing.

Dividend is Irrelevant for your Financial Planning

Dividend investing is largely irrelevant for younger investors who are in the wealth accumulation phrase of their financial journey. Investors at this stage are actively earning income and working to grow their wealth. In this context, dividend income is redundant since you already have a primary source of income to cover your expenses. Receiving dividends is akin to drawing down your portfolio, for no purpose, only for you to reinvest them and incur additional and unnecessary transaction costs. Further, if you are invested in the SG market, your dividend is likely to be sitting out of the market while you await them to accumulate enough for purchasing the minimum lot. On the other hand, those invested in the US market will have their dividends taxed by the dividend withholding tax. 

The flaw of a dividend investing strategy is even more apparent for retirees who depends on their portfolio for income during their retirement years. For retirees, a crucial consideration is securing a stable inflation adjusted income. However, relying on dividends is grossly inefficient because dividend payouts can vary significantly from year to year, contingent on market conditions and dividend decisions made by company management. To illustrate, using the Allianz Income & Growth fund, which purported to pay more than 8% dividends. Suppose a retiree retired in 2013 and counted on this fund for income, and assuming he received $3000 per month initially. Today that retiree would only be receiving a monthly payout of $2,200 per month due to a reduction in dividend. Not only would this retiree fail to keep up with inflation, but he would also have to live by with a substantially lower real income.

This is contrary to the Safe Withdrawal Rate (SWR) approach, which takes a total return perspective and makes no distinction between dividend income and capital. Under the SWR, retirees determine how much money they can withdraw from their portfolio each year (by selling portion of the portfolio) while maintaining a low risk of running out of money before reaching the end of their lives. It is a conservative strategy that tries to balance having enough money to live comfortably with not depleting retirement savings prematurely. For instance, a retiree with a $1 million retirement portfolio may, as a rule of thumb, draw $35,000 (or 3.5%) in his first year of retirement, and adjust the withdrawal amount in subsequent years to account for inflation.

To sum up, the preference for dividend cashflow may come at the expense of dividend investors' overall financial gains. The allure of cashflow, while appealing, often proves to be a concept more idealized than practical. The benefits of dividend cashflow primarily exists in the mind of the less informed investors and do not offer any substantial advantages in guiding investors' investment or financial planning decisions. 

The content shared in this post is just my opinion and should not be taken as financial advice. In fact, you should never treat what a random dude shared online as financial advice, no matter how credible they may sound.