Why Dividend Strategies Don't Live Up to the Hype and what you Should do Instead

Dividends are not a good proxy for sustainable income

Argument 1: I buy high-dividend companies, as I can then spend the dividend while my assets stay intact.

Alas: Dividend is NOT a good proxy for the income you can take from your investments.

Dividends are not a good proxy for cash flow because companies increasingly use stock buybacks, which is better from a tax perspective for most investors. Companies have embraced the notion that dividends are not very important anymore. Indeed, stock buybacks now amount to over ⅓ of the yield of the S&P 500 companies.

More fundamentally, current cash flow is not a good proxy for future cash flow. How companies are valued in practice depends on their growth rate. A company with high dividends and zero growth is valued much less. Consider that you have a portfolio of companies with declining dividends. Would you then each year reduce your spending in nominal — let alone real terms? 

Tip: As explained below, a sensible withdrawal strategy while investing in a better-performing stock makes much more sense. 

A high dividend is not a good indicator of the soundness of companies

Argument 2. High dividend companies and sectors are robust. They have proven that they are profitable.

Alas: High dividend companies are NOT more sustainable; on the contrary, they may signal an endgame.

Companies that pay high dividends tend not to have good investment possibilities, and hence, lower growth and create lower shareholder value. Their stock price grew less, and stock price is the indicator of value for the market and also value for you as it can be sold at that value. 

You also find end-game companies that stop investing altogether. The tobacco industry and, increasingly, the oil companies.

Point in case: If we compare the S&P 500 with the high dividend version highlighted by Morningstar, then you can see a very significant underperformance — taking, as usual, the longest time series available.

SPDR® S&P US Dividend Aristocrats UCITS ETF (UDVD)

It does not improve the stability of your portfolio

Argument 3. High-dividend companies have more stable stock prices

Alas: High dividend companies do not have more stable stock prices.

There is no meaningful reduction in the maximum dropdown. See, for example, the graph above, as high dividend stocks also suffer from sell-offs during crises. In any case, there is no meaningful reduction in volatility. 

Invest in the corporate sector as a whole

As an investor, you need to be keenly aware that there is no stability in individual sectors, let alone in individual companies. Some sectors flourish and then eventually disappear. Creative destruction is what Schumpeter called this process, where companies and sectors compete, innovate, and whither or die. Sectors may survive, but their profitability evaporates. 

Railroads were the biggest investment sector of the 19th century, and now they are an insignificant part of the economy, and now it is just shy of 1 percent in the USA.

The most stable solution in the end is to invest in the corporate sector as a whole. Why is there stability in the sector as a whole? Because we need the corporate sector to produce what we need as consumers efficiently in our capitalist system. The capitalist system has shown to be far more effective than the alternative communist, where companies are government-owned. Therefore, as long as the capitalist system prevails, one can count on the corporate sector to be needed and, over time, to grow more or less in line with the economy itself. 

We suggest these alternatives:

What are our concrete alternative recommendations?

1. Stay invested in wide-spread indices, but have a sensible withdrawal strategy. 

2. If you cannot stand the volatility of a normal, well-spread economy-wide portfolio, mix bonds in your portfolio.  

Sensible withdrawal rules

If you are invested wisely in a widespread index, your portfolio value is relatively stable and most likely to grow well, with limited long-term downward risk.

This then forms an essential basis for withdrawing money from your portfolio in a relatively predictable and stable manner.

The literature suggests portfolio rules that allow you to withdraw a steady amount from your initial portfolio (say 4%) and then increase this amount with inflation whenever the return in the previous year was positive. Your portfolio should, on balance, still grow over the years.

This rule is 95% proof for all historical situations. To make it 100%, you can add some safety valves. Cut back your spending by 20% if the portfolio drops below 50% of the initial value, or supplement your income with a part-time job in the same way until it is restored to 80% of the original value.

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Adding bonds

Investing in government bonds — NOT corporate bonds! — reduces your volatility and, more importantly, your maximum drawdown: that is, the maximum loss from one year to another in your portfolio. It does come at a significant reduction in returns and exposure to long-term inflation risk.

We would only use such a solution sparingly if you really cannot afford the risk.