"Over the long run [dividends] provide the bulk of equity investors’ returns." Buttonwood, The Economist
There’s a big sell out there about dividends right now. The baby-boom generation is moving into retirement and needs income. Bond yields are low and dividend yields are high by comparison. Everyone wants dividends! As a result so many investment management firms are playing to investor’s needs the only way they know how - by launching high income funds and dividend focused ETFs. In support, reams of classic and modern research papers about the long term outperformance of dividend stocks have been dusted off and despatched. We’ve covered some of those papers in recent pieces on the site, but some highlights from them include claims such as:
- Over 200 years, equities have returned 7.9% annually, 73% of which has been due to dividends and dividend growth.
- Dividend stocks offer downside protection, are low volatility, and provide 90% of the return from stocks in bear markets.
If you believed the hype, you’d surely throw all your money into dividend stocks and sit back and prosper. While that may be a very good strategy according to the research, very few investors have ever been able to achieve these fabled results in the real world. The reasons why are very simple and mostly due to a pair of extremely simple mistakes. Ensuring you don’t make these mistakes in your own investing can at least give your portfolio a higher chance of outperforming over the long run.
1. Not buying dividend stocks in tax-efficient wrappers
It’s so easy to be a sucker to the high dividend story unless you recognise that almost all those stellar gains reported in the research reports do not account for tax!. In the real world, dividends are taxed as income which creates a massive drag on reported returns.
Historically, dividends have almost always been taxed less favourably than capital gains. According to research by Legg Mason Capital, in the US over the last 50 years dividends have been taxed on average at a rate of 50%. Meanwhile in the UK, dividends are taxed on a sliding scale according to your income band meaning that top-rate tax payers pay an awful lot more for dividend income than capital gains.
The other issue with income taxes is that they have to be paid immediately. Capital gains taxes can be deferred until they are realised which means they essentially become an interest free loan - providing leverage in your portfolio that can compound growth rates.
Aswath Damadoran illustrates in his book “Investment Fables” that if you actually factor in the drag that these high income taxes have on dividend stock strategies they actually massively underperform the market! A complete inversion of the assumption that dividend stocks outperform.
But it’s not all bad. You can benefit from the reported outperformance of dividend stocks as long as you always buy them in a tax-efficient wrapper like an ISA or a SIPP in the UK. With these investment accounts taxes are either waived or deferred allowing dividend income to accrue and allowing it to be reinvested at the full face amount. One of the biggest mistakes an investor can make is to forget this.
2. Failing to reinvest dividend income systematically
There’s a famous fable about an arrogant young Sultan prince who challenged all comers to a game. Boasting of his boundless wealth, the prince offered the winners the prize of their choice. A canny courtier decided to teach him a lesson asking for the winner’s prize to be a chess board with one square each day to be filled with rice - a single grain on the first square, 2 on the second, 4 on the third and doubling in number until the board was filled after 64 days. The prince, thinking he was mocking him by asking for such a measly prize, agreed and subsequently lost the game. Little did he know that by the 64th day the courtier would be demanding 18,446,744,073,709,551,615 grains of rice - a number which could fill the surface of the entire earth several times over!
This is the power of compound interest which was once described as the eighth wonder of the world by Warren Buffett. It’s precisely this little trick that has propelled his own wealth to the stratosphere as one of the richest men on the world. While Berkshire Hathaway (his company) doesn’t pay dividends, almost all of its subsidiary companies do to the parent group of which he has control, and Warren gets to reinvest those cashflows (dividends) quite systematically. This constant reinvestment of cash into high yielding businesses has had a compounding impact which has grown his fortune quite dramatically.
Every study into the wealth that can be achieved from dividend strategies has relied on the assumption that all dividends are reinvested back into new shares of the underlying company. In fact a recent BlackRock paper has shown that from 1900 to 2010, $1 invested in US stocks with reinvested dividends became $851, whereas without it became just $8.50. By consistently reinvesting dividends, in bear markets or bull, investors can ensure that they are exposed as much as possible to this power of compounding, not only growing their stake in each company, but growing their exposure to price appreciation and dividend growth.
But the evidence is that most investors do not do this! In fact most investors receive dividend cheques in the post and spend the income quite happily. Very few take advantage of so called DRIPs (dividend reinvestment plans) or even better reinvest their dividends systematically themselves. And when investors do reinvest their dividends they are most likely to do so during bull markets, not during the bear markets when dividend reinvestment can provide the ‘return accelerator’ described by Jeremy Siegel in his book ‘The Future for Investors’. Without a consistent dividend reinvestment strategy, dividend investors can only expect sub-par investment returns from dividend stocks.
So in summary, if an investor does seek to take advantage of the potential upside from dividend income strategies, they must ensure they maximise their chances of outperformance by using tax shelters and reinvesting dividends. If you don't, you might not end up eternally indebted like our Sultan prince, but your returns will certainly be extremely disappointing!Follow edcroft on Twitter