Blog

Kent Kramer

With five-year CD rates averaging 1.56% annually and money market annual yields remaining below 0.29% (Wall Street Journal Market Data – Feb. 22, 2018), investors continue to ask if there is anything they should do to increase the cash flows coming from their portfolios. A popular answer coming from some corners of the financial press is to seek out high dividend paying stocks.

Unfortunately, this strategy for increasing cash flow may result in lower total returns to investors and increased risk in their portfolios. Here’s why.

In our view, investors should pursue a total return approach to portfolio construction. After all, if the overall wealth in two stock portfolios having similar risk and return expectations grows by eight percent in a given year, it doesn’t really matter whether the increase in value was all due to appreciation or a combination of dividends and appreciation. At year end, both portfolios have the same value. If the owner of Portfolio B needed cash, he or she could create a “homegrown” dividend by selling a few shares from the portfolio. If not, the owner had tax-deferred growth in the appreciated shares.

Beginning Value Appreciation Dividend Ending Value Stocks Ending Value Cash Total Ending Value
Portfolio A $100,000 6% ($6,000) 2% ($2,000) $106,000 $2,000 $108,000
Portfolio B $100,000 8% ($8,000) 0% ($0) $108,000 $0 $108,000

 
The idea that rational investors will “…prefer more wealth to less and are indifferent as to whether a given increment to their wealth takes the form of cash payments (dividends) or an increase in the market (appreciation)” was outlined in a highly regarded 1958 paper by academics Merton Miller and Franco Modigliani1. They demonstrated that dividend policy should be irrelevant to stock returns, and their conclusions are still very convincing over fifty years later.

From this theoretical starting point, we can look at two real world examples of how some investors, by pursuing a high dividend strategy, may have unwittingly settled for a lower total return or dramatically increased the risk in their overall portfolios.

Potential Underperformance

Effective diversification is a good way to reduce the overall risk of a portfolio. Additionally, diversification can be used to increase the probability of getting the full return of a market. For example, if an investor’s goal is to achieve the return of the S&P 500 stock index in a given year or decade, the highest probability method for achieving that goal is to own the complete index over the entire time period. If the investor does not own all the stocks in the index, or does not own them every day, there is an increased statistical likelihood that the investor’s total return will differ from the index. There are many studies showing that even among professional money managers, the majority of those who attempt to “beat the market” by holding a subset of the market generally fail to do so.

The Vanguard Group, a leading provider of diversified index funds, manages the High Dividend Yield Index ETF (VYM). The fund owns the stocks of US large companies that have paid above-average dividends for the previous 12 months. The table below compares the results of this fund with the complete S&P 500 Index of US large company stocks regardless of dividend policy for periods ending December 31, 2017.

1 Year 5 Year Annualized 10 Year Annualized Dividend Yield* Standard Deviation (Risk) Number of Holdings*
VYM2 16.45% 15.09% 8.61% 2.79% 14.60% 397
S&P 500 Index3 21.83% 15.79% 8.50% 1.74% 15.08% 505

 
The data appears to support the conclusions of Miller and Modigliani that dividend policy has little long-term impact on stock returns. However, the reduced diversification of the high dividend paying strategy can result in years when the investor receives less (as in 2017) or more than the total market, depending on the underlying holdings.

When Pursuing Yield Increases Risk

In relatively long bull markets for stocks, like those we have seen since mid-2009, investors can be subject to a version of recency bias that forgets or ignores the potential downside risk of stocks regardless of dividend policy. Consider the dividend yield of VYM. In 2017, the appreciation in the fund (capital return by Net Asset Value) was 13.02%, and the cash dividends (income return) were 3.4%2. That 3.4% dividend yield, compared to the recent 1.5% yield on five-year CDs, looks inviting as an investment that has both appreciation potential and relatively strong current yield.

However, that combination comes with a price – the risk of loss. In 2008, VYM’s total return was -32.16% consisting of an income return of +2.32% and a capital loss of -34.70%2.

It is important to keep in mind the primary purposes of the different investments held in diversified portfolios. Stock investments primarily provide long-term growth while bonds and cash control risk and provide liquidity (available cash) whenever needed. High dividend paying stocks are still stocks and come with all the market risk of other stock market investments. The table below shows the comparative risk and return of the broad US stock and bond markets.

1 Year Total Return 5 Year Total Return 10 Year Total Return Standard Deviation (Risk) 2008 Total Return
S&P 500 Stock Index4 21.83% 15.79% 8.50% 14.78% -37.60%
Bloomberg Barclays US Aggregate Bond Index4 3.54% 2.10% 4.01% 3.81% +5.24%

 
The bottom line is that research shows dividend paying stocks are not uniquely valuable to an investor’s stock portfolio. On their own, they do not provide an advantage in total return or diversification. And most importantly, they do not provide risk control when it is needed most. Total return portfolios create a higher probability of achieving market returns and provide the investor with flexibility as to when they want to convert investments to cash.

  1. Modigliani, F.; Miller, M. (1958). “The Cost of Capital, Corporation Finance and the Theory of Investment”. American Economic Review. 48 (3): 261–297
  2. Source: Vanguard
  3. Source: Vanguard
  4. Source: Dimensional Fund Advisors

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