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It's no coincidence that investors consider dividends to be an essential component of their investment strategy. As we reviewed in a previous lesson of this dividend investing course, 51% of the S&P 500's cumulative return came from reinvesting dividends between 1988 and 2019.
Source: Finbox Chart Based On Data From Yahoo Finance
Furthermore, from March 2009 to March 2019, the Dividend Aristocrats Index—which consists of S&P 500 stocks that have increased dividends for 25 consecutive years or more—beat the market with a 19.35% annual return, versus the 17.56% of the S&P 500 Index.
These results make investors believe dividend investing is a proven strategy to beat the market. In this lesson, we will analyze several limitations of dividend investing, to explain why dividends are not that important unless you're looking for passive income.
Dividends Are Neutral To Shareholders Value
Receiving a payment directly into the bank account is a nice feeling for many dividend investors that believe the payment is a way to increase their wealth. However, this is a common misconception.
As we discussed in this lesson, dividends are not a way to increase shareholder wealth, but to distribute part of the company's income to shareholders. Let's make that clear with an example:
Me and a friend, Andy, buy two different stocks for $150. Andy receives a $15 annual dividend while I don't because my company uses the funds to invest and grow the business.
When a company pays a dividend, its price drops by the same amount. So when Andy receives the payment, we both have $150, however, he has $15 in cash and a $135 stock, while I have a $150 stock. As you can see, dividends are neutral to shareholder value (excluding the impact of taxes), and their main role is to provide liquidity and distribute part of the company's value to shareholders.
Dividend Investing And The Mental Accounting Bias
In 1985, American economist Richard Thaler published a paper titled Mental Accounting And Consumer Choice. In it, he explains how people treat money differently based on circumstances - such as the money's origin and expected use, instead of thinking about it in terms of absolute value. Here's an example from the paper:
Mr. and Mrs. L went on a fishing trip in the northwest and caught some salmon. They packed the fish and sent it home on an airline, but the fish were lost in transit. They received $300 from the airline. The couples take the money, go out to dinner and spend $225. They had never spent that much at a restaurant before.
The same process occurs in investors' minds when they receive dividends. They feel like receiving money for doing nothing, and they consider them more valuable because of the money's origin. But in reality, it doesn't make any difference to shareholder wealth to receive the money in their bank account or have them in stock holdings.
Dividend Stocks: A Limited Universe
Finding good value investment opportunities can be very difficult especially when the market keeps reaching new historical highs. It becomes even more challenging if you decide to limit your possible investments just to dividend-paying stocks.
Almost 84% of companies in the S&P500 paid dividends in 2015, while dividend-paying stocks in the mid-cap and small-cap indexes were 70.5% and about 54%, respectively, according to FINRA.
This downtrend is expected to continue because, as discussed in the dividends vs. buybacks lesson, more companies have started preferring buybacks since they can provide shareholders with higher returns over the long term thanks to tax efficiency. Here's the evidence—from March 2009 to March 2019, the Dividend Aristocrats Index had an annual return of 19.35%, versus the 21.09% return of the S&P 500 Buyback Index.
As you can see, dividend investing considerably restricts your stocks picking universe and could make you miss some valid investment opportunities. So why should you limit your choice only to companies that pay dividends when there are alternatives that can make you much more money in the long run?
Dividends Are Not Predictive Of Future Returns
As mentioned above, the Dividend Aristocrats Index beat the market by 1.79% per year from March 2009 to March 2019. However, there is no evidence this excess return is due to dividends.
Dividend aristocrats are some of the greatest companies in the United States. Their ability to increase dividend payouts for 25 consecutive years or more demonstrates their financial strength, growth, and economic moat. Those are exactly the factors that may have contributed to their excess return—they would have probably beaten the market even if they had not paid any dividends.
As our trusted readers already know, we are data-driven investors. So let the data speak for itself!
In his book, What Works On Wall Street, James O'Shaughnessy examined dividend yield as a potential quantitative metric to identify value stocks that can beat the market. It also tested other metrics such as EV/EBITDA or the P/E ratio and found out that the dividend yield didn't produce the same value premium of the other ratios.
While stocks with the lowest PE ratio or EV/EBITDA significantly outperformed the market, stocks with the highest dividend yield didn't. What's more, stocks in the top decile (those with the highest dividend yield) underperformed the 2nd, 3rd, and 4th deciles (those with a lower dividend yield).
In this paper from Dimensional Fund Advisors, Stanley Black compares the returns of global developed market dividend-paying stocks to non-dividend-payers between 1991 and 2012 and finds out that they had the same return.
These studies are reliable and provide clear evidence that dividends were not the factor that made dividend aristocrats outperform the market.
Not only are dividends not correlated with above-average investment performance, but they also have several limitations such as poor diversification and tax inefficiency.
So, if you're looking for passive income and need a regular payment in your bank account, dividend investing is one of the better solutions for you. Otherwise, if you are investing to build long-term wealth, there is no reason to limit your portfolio to dividend-paying stocks. In this article, you can find three active investment strategies that may be better options than dividend investing.