Beacon Financial Strategies NC

Dividends are Only One Factor When Investing in Stocks

In Asset Allocation, Investments, Personal Finance, Retirement Planning by Chip Hymiller

This is a common question we receive from clients: 

Shouldn’t my portfolio be primarily allocated to dividend paying stocks in retirement? That way my portfolio will almost fully generate the income I need to cover living expenses.

The answer to this question varies on a person-by-person basis, but for most the answer is a resounding no. Let us explain…

When investing in stocks, returns are comprised of two components 1) dividends and 2) stock price appreciation (or depreciation). Companies that have higher dividend rates are generally more mature companies that have lower expected growth rates.  Also, stocks with higher dividend yields commonly operate in the utilities, energy, real estate or other defensive and highly cyclical sectors.

In contrast, companies that have no, or low dividend rates are generally those in growing industries, or economic sectors.  Therefore, company profits are used to fuel growth through research and development, acquisitions and mergers (and not paid as dividends). Smaller companies, or those in technology, biotech, or other high-growth sectors generally have no or low dividend yields.

As a point of reference, diversified stock indexes currently have dividend yields in only the 2% range or lower when adding exposure to smaller companies.  Historical research has shown that long term portfolio returns are significantly enhanced by having exposure to these smaller, growing companies—it is an area we prefer not to ignore for our clients.

Is it possible to build a diversified portfolio with only dividend paying stocks?

To find out, we screened a database of more than 20,000 stocks.  We eliminated stocks that had dividend payouts of less than 3.5%, any that were thinly traded and those that had “health” ratings that were lower than top notch. 

The result?  20,000 stocks were reduced to only 56!  Of these 56, 34 (61%) were in the energy, real estate or financial sectors – each of which commonly experience boom and bust periods. In addition, only 1 stock was in the technology and health sectors respectively —two of the most important sectors fueling economic growth.

How did these dividend-paying stocks perform?

The average performance of the 56 stocks in this screen underperformed the S&P 500 by nearly 5% annualized over the last 3 years and by 3.5% annualized for the last 5 years. In fact, only 9 of the 56 stocks outperformed the S&P 500 index over the last 5 years. 

Dividends are not guaranteed!

Many investors fail to recognize that dividends are not guaranteed. In fact, there are many examples of companies cutting and even eliminating dividends. GE and Pacific Gas and Electric (California’s biggest power company) have both recently slashed dividends and are struggling to stay afloat.  When a company struggles to meet its financial obligations,  dividend payments are one of the first expenses cut.

We Prefer a Total Return Approach

While, on the surface creating a dividend-focused portfolio to meet income needs seems simple and intuitive, in reality this approach can expose investors to more risk and a disappointing outcome.

At Beacon, we subscribe to the academically proven total return investment philosophy.  A total return approach focuses on completely diversifying company-specific risk by owning “the whole market.” 

Through this approach, your portfolio contains a diversified mixture of stocks and bonds of all types (including dividend paying stocks).  The risk and return characteristics are dependent on your income needs and risk profile and are controlled by the percentage allocation to both stocks and bonds. 

Over the long run, those who subscribe to this proven approach will benefit from more predictable results and an improved investor experience.