The reality of income or dividend investing, however, is not so clear. First there’s the question of whether you can generate sufficient yield from stocks and bonds to fund your retirement. A 4% yield in todays interest rate environment is no easy feat.
More fundamentally, the dividend approach to retirement investing misunderstands the value of dividends and their place in an investment portfolio. Some seem to think that dividends are “free” because investors receive a return without needing to sell part of their investment. There is no free lunch, and dividends are no exception.
In fact, there are some distinct disadvantages to dividends. In this article, we’ll look at those disadvantages in detail. We’ll also look at the benefits of investing in companies that pay a dividend. And then we’ll consider these pros and cons in light of retirement investing.
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How Dividends Work
Before we get to the pros and cons of income investing, it’s important to understand how dividends work. Specifically, we need to look at what happens to the price of a stock when a company pays a cash dividend.
4 Key Dividend Dates
There are four key dates to understand when it comes to dividends:
Declaration Date: The date the board of directors declares the amount of a dividend
Record Date: The date upon which the legal owners of the shares are entitled to the dividend
By the declaration date and the record date are set by the board of directors and included in a company’s press release. From the record date the ex-dividend date can be calculated.
Ex-Dividend Date: Two trading days before the Record Date. Purchases of shares on this date or later are NOT entitled to the dividend.
Payment Date: The date the dividend is paid.
Let’s look at an example. Last month Qualcomm announced a cash dividend of $0.48 per common share. According to the press release, the dividend is payable on December 18 to shareholders of record at the close of business on December 1. From this we can calculate the Ex-Dividend Date: November 27 (two trading days earlier).
If you buy the stock on November 26th you’ll be entitled to the dividend, even if you sell the stock before the dividend is paid. Conversely, if you buy the stock on November 27th, you won’t be entitled to the next dividend payment, even if you still own the stock on December 18 when the dividend is paid. You’ll have to wait until the next quarterly dividend is paid.
There’s another detail about the ex-dividend date that is critical for dividend investors to understand. At the start of trading on the ex-dividend date, the opening price of a dividend paying stock will be marked down by the amount of the dividend.
Sticking with Qualcomm, it’s stock price will open on November 27 $0.48 less than it closed the day before. It’s currently trading at almost $50 a share. Further, millions of shares trade hands every day and the price of the stock rises and falls for any number of reasons. As a result, most shareholders won’t even notice this adjustment. But it’s important to understand.
When shareholders receive the dividend, they aren’t getting “extra” money. Instead, part of the company’s capital is being returned to investors, and their value of their remaining investment is reduced by the same amount.
With that in mind, let’s turn to 5 key disadvantages of dividend investing.
5 Disadvantages of Dividend Investing
There are five distinct disadvantages of dividend investing.
- You Don’t Control the Amount: The board of directors sets the company’s dividend policy. Shareholders have no meaningful control over the amount of the dividend. As a result, it may or may not be the amount a retiree needs at that moment in time. In contrast, when an investor sells a portion of his or her investment, they have full control over the amount.
- You Don’t Control the Timing: Most cash dividends are paid out every quarter. That being said, investors have no control over the timing. Dividends are paid out regardless of whether an investor needs or wants the return of capital.
- Taxes: In most cases 100% of cash dividends are taxable (outside retirement accounts). In contrast, the sale of a portion of an investment is only taxable to the extent it represents a taxable gain.
- Reaching for Yield: Dividend investing can encourage investors to take on extra risk in order to achieve a desired yield. The S&P 500’s yield today is roughly 2%. That’s not nearly enough for most retirees trying to live on income.
- Believing Dividends are Free: Because dividends enable investors to pocket cash without selling part of their investment, dividends are often seen as the icing on the cake. They are not, which is why we walked through the payment cycle of dividends above. Every dollar a company pays in dividends is a dollar they can’t reinvest into the company. There is no free lunch.
3 Advantages of Dividends
The above is not to suggest that dividends are paid. In fact, most of the companies I own pay a dividend (Berkshire is the lone exception). Here are 3 pros to dividend investing:
- Dividends show that management is focused on shareholders: One of the biggest hurdles for an investor is finding companies run by competent managers who put shareholders ahead of themselves. The payment of a dividend is no guarantee that you’ve found such a company. But it’s a good start.
- Dividends usually shows a stable, mature company: Companies that pay a dividend are usually large, stable companies with a good performance track record. Again, this is a generalization, but I’ve found it to be true. This doesn’t mean that all dividend payers are good investments. But of a company doesn’t pay a dividend, an investor should understand why before investing in the company.
- Dividends may continue in down markets, but not always: Even when the stock market falters, dividends often continue. For a retiree it may help you avoid selling shares during a down market. Of course, in some cases companies lower or eliminate dividends during a down market. During the Great Recession, for example, companies in the auto, housing and banking industries eliminated their dividends.
Not convinced that dividend investing, even with some advantages, has some serious disadvantages? Perhaps Warren Buffett will convince you. In his 2012 Berkshire letter to shareholders, he as an excellent discussion of dividends beginning on page 19. It’s a must read.
When it comes to investing at any age, the key is to focus on good companies trading at or below intrinsic value. Whether they pay a dividend is secondary, although most of the good companies do. In retirement, rather than relying on dividends, consider a bucket strategy, something I discuss with Dr. Wade Pfau in a recent interview.