Dividend We Fall
The past two weeks, we have observed the mechanics behind dividend payments and how dividends are not “free” income as well as whether dividend paying funds lead to higher return for investors. Today’s insight concludes our 3-part series, highlighting important pitfalls to watch out for when focusing on a dividend yield strategy.
In 1988, almost 70% of all cash returned to shareholders came in the form of dividends. By 2016, the preferred way of returning cash to shareholders came in the form of share buybacks — accounting for almost 60% of all cash returned to shareholders. In 2021, only 38% of U.S. companies paid a dividend.
Shrinking opportunity set
By focusing only on dividend paying companies, you give up a world of opportunity.
This trend is not only pronounced in the U.S. but also applies to firms globally as well. This is important because research has shown that the vast majority of stocks do not create wealth for investors on average and by focusing only on a small subset of the stock market, you might be putting your investments at undue risk. Here are some things that you have to be aware of:
1. Dividends are not contractual obligations
Unlike a bond which pays coupons, companies can cut dividends without legal consequence. Dividend policy can also be volatile especially during times of higher uncertainty e.g. during the pandemic. In the first three quarters of 2020, dividends from each dollar invested in the U.S. markets decreased by 22% compared to the same period in 2019.
2. Beware of high dividends
When companies are in decline, they may start paying large dividends as assets are sold to fund the payouts. This is not sustainable and will eventually run out sooner than later. Focusing on high dividend stocks also introduces possible concentration risk. For example, in 2008, you would have been holding five banks in your dividend portfolio, a shock to the sector will send your portfolio into collapse.
3. The market knows something that you don’t
Very often, dividend yield shoots up because the stock price has cratered and not because the dividend has been increased. This can indicate that the market is expecting future problems for the stock; naive investors investing solely based on dividend yields might get caught unknowingly.
Investors do not need to subjugate their portfolios to unnecessary risk by focusing on a dividend strategy to generate income.
When we are designing income solutions for our clients, we are agnostic to all sources of income, whether it comes from dividends, fixed income coupons, or capital appreciation. Our solutions are designed such that the income source is robust, stable and resilient in the face of shocks and crisis.
There is a better way to invest
Experience the difference today with a wealth manager that is aligned with your interests.
GYC applies the best ideas from financial science to develop a financial plan that is built upon a rigorously tested investment philosophy.