Focusing On Buying Dividend Paying Stocks Is A Mistake

Picking the right stocks to invest in is not an easy process, but all too often I see retail investors make the mistake of narrowing their investment research to just stocks that pay dividends. This is a common mistake that investors make, and in this article, we are going to cover the total return approach versus the dividend payor approach to investing.  

Myth: Stocks That Pay Dividends Are Safer

Retail investors sometimes view dividend paying stocks as a “safer” investment because if the price of the stock does not appreciate, at least they receive the dividend. There are several flaws to this strategy. First, when times get tough in the economy, dividends can be cut, and they are often cut by companies to preserve cash.  For example, prior to the 2008/2009 Great Recession, General Electric stock was paying a solid dividend, and some retirees were using those dividends to supplement their income. When the recession hit, GE dramatically cut it dividends, forcing some shareholders to sell the stock at lower levels just to create enough cash to supplement their income. Forcing a buy high, sell low scenario.

The Magnificent 7 Stocks Do Not Pay Dividends

In more recent years, when you look at the performance of the “Magnificent 7” tech stocks which have crushed the performance of the S&P 500 Index over the past 1 year, 5 years, and 10 years,  there is one thing most of those Magnificent 7 stocks have in common. As I write this article today, Nvidia, Microsoft, Google, Amazon, and Meta either don’t pay a dividend or their dividend yield is under 1%.  So, if you were an investor that had a bias toward dividend paying stocks, you may have missed out on the “Mag 7 rally” that has happened over the past 10 years.

Growth Companies = No Dividends

When a company issues a dividend, they are returning capital to the shareholders as opposed to reinvesting that capital into the company.  Depending on the company and the economic environment, a company paying a dividend could be viewed as a negative action because maybe the company does not have a solid growth plan, so instead of reinvesting the money into the company, they default to just returning that excess capital to their investors.  It’s may feel good to have some investment income coming back to you, but if you are trying to maximize investment returns over the long term, will that dividend paying stock be able to outperform a growth company that is plowing all of their cash back into more growth?

Companies Taking Loans to Pay Their Dividend

For companies that pay a solid dividend, they are probably very aware that there are subsets of shareholders that are holding their stock for the dividend payments, and if they were to significantly cut their dividend or stop it all together, it may cause investors to sell their stock. When these companies are faced with tough financial conditions, they may resist cutting the dividends long after they really should have, putting the company in a potentially worse financial position knowing that shareholders may sell their stock as soon as the dividend cut is announced.

Some companies may even go to the extreme that since they don’t have the cash on hand to pay the dividend, they will issue bonds (go into debt) to raise enough cash for the sole purpose of being able to continue to pay their dividends, which goes completely against the reason why most companies issue dividends.

If a company generates a profit, they can decide to reinvest that profit back into the company, return that capital to investors by paying a dividend, or some combination of two. However, if a company goes into debt just to avoid having to cut the dividend payments to investors, I would be very worried about the growth prospects for that company.

Focus on Total Return

I’m a huge fan on focusing on total return.  The total return of a stock equals both how much the value of the stock has appreciated AND any dividends that the stock pays while the investor holds the stock.   If I gave someone the option of owning Stock ABC that does not pay a dividend and Stock XYZ that pays a 5% dividend, a lot of individuals will automatically start to build a strong bias toward buying XYZ over ABC without digging much deeper into the analysis.  However, if Stock ABC does not pay a dividend due to its significant growth prospects and rises 30% in a year, while Stock XYZ pays a 5% dividend but only appreciates 8%, the total return for Stock XYZ is just 13%. This means the investor missed out on an additional 17% return by choosing the lower-performing stock.

Diversification Is Still Prudent

The purpose of this article is not to encourage investors to completely abandon dividend paying stocks for growth stocks that don’t pay dividends.  Having a diversified portfolio is still a prudent approach, especially since growth stocks tend to be more volatile over time. Instead, the purpose of this article is to help investors understand that just because a stock pays a dividend does not mean it’s a “safer investment” or that it’s a “better” long-term investment from a total return standpoint. 

Accumulation Phase vs Distribution Phase

We categorize investors into two phases: the Accumulation Phase and the Distribution Phase. The Accumulation Phase involves building your nest egg, during which you either make contributions to your investment accounts or refrain from taking distributions. In contrast, the Distribution Phase refers to individuals who are drawing down from their investment accounts to supplement their income.

During the Accumulation Phase, a total return approach can be prudent, as most investors have a longer time horizon and can better weather market volatility without needing to sell investments to supplement their income. These investors are typically less concerned about whether their returns come primarily from appreciation or dividends.

As you enter the Distribution Phase, often in retirement, the strategy shifts. Reducing portfolio volatility becomes crucial because you are making regular withdrawals. For instance, if you need to withdraw $50,000 annually from your Traditional IRA and the market drops, you may be forced to liquidate investments at an inopportune time, negatively impacting long-term performance. In the Accumulation Phase, you can ride out market declines since you are not making withdrawals.

Times Are Changing

Traditionally, investors would buy and hold 10 to 30 individual dividend-paying stocks indefinitely. This is why inherited stock accounts often include companies like GE, AT&T, and Procter & Gamble, known for their consistent dividends.

However, the S&P 500 now features seven tech companies that make up over 30% of the index's total market cap, driving a significant portion of stock market returns over the past decade, with very few paying meaningful dividends. This article highlights the need for investors to adapt their stock selection methodologies as the economy evolves. It’s essential to understand the criteria used when selecting investments to maximize long-term returns.

Special Disclosure: This article does not constitute a recommendation to buy or sell any of the securities mentioned and is for educational purposes only.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.