When it comes to investing, there are usually detailed, seemingly murky, questions that often upspring which require some digging into. For example: Should I be investing for dividend yield? Is it safer to invest in dividend stocks? Are dividend stocks good to own in retirement?
Abacus’ advisors have been fielding many of these questions lately well-nigh investing in dividend stocks. It’s not surprising. We often get inquiries well-nigh what investment tideway has recently been hot – and 2022 favored dividend paying stocks.
Let’s explore and find some clarity.
What is Investing for Dividends?
First, let’s pinpoint what investing for dividends means. An investor’s total stock return is derived from two sources. One is wanted appreciation, or an increase in the stock’s price. This is similar to your home increasing in value. You can’t spend the proceeds until you sell the house, but you are moreover not taxed until you sell.
The second source of stock returns is dividend yield, or payments made by companies to shareholders at regular intervals. This is like receiving rent for leasing your house. You are taxed every time you receive them. Together, wanted appreciation and dividend yield subsume total stock return.
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How Dividend Investing Works in Practice
Let’s squint at two very variegated examples of dividend paying stocks.
Apple pays a dividend that is 0.5% of its price (as of this writing). Apple’s shares moreover increased in value by 19% over the prior 12 months. For Apple, dividends have been, and are expected to, play a small role while wanted appreciation has been, and will likely be, the main suburbanite of its returns.
Johnson & Johnson pays a 2.8% dividend, increasingly than five times greater than with Apple. Dividends are a far larger portion of its long-term expected returns. Investment funds that target dividend paying stocks focus increasingly on companies like Johnson & Johnson and less on companies like Apple.
Most companies don’t pay a dividend at all. Over time, it has wilt much less common. 68% of US companies were paying dividends in 1927, while only 38% of firms paid in 2021.
How Dividend Paying Stocks Underperform
If you superintendency well-nigh maximizing your income, focusing on dividend paying stocks has not been an constructive strategy. Dividend paying stocks have underperformed stocks in unstipulated over the long term.
The Vanguard Dividend Growth bilateral fund (SYMBOL: VDIGX) has been virtually since 1992 and made Morningstar’s list of The Weightier Dividend Funds in 2023. Here we will let it represent dividend stocks. And we will compare its performance to the SPDR S&P 500 ETF (SYMBOL: SPY), a fund which invests in the alphabetize that most people think of as ‘the stock market.’
As Exhibit 1 unelevated illustrates, over 30 years and 7 months, the VDIGX underperformed SPY by 1.1%, on average, annually. Over this period, that lower return dented comparative total returns by 27%. And remember, this fund is one of the largest performing dividend funds (as well as one of the oldest).
There are other reasons not to favor dividend stocks. A focus on dividend yield sacrifices sector diversification. Upper dividend yields tend to occur in companies well-matured in consumer staples, utilities, telecoms, energy, and real estate. This can expose an investor to significant sector-specific risks.
Why a Diversified Portfolio May Be a Largest Choice
A diversified portfolio, on the other hand, spreads investments wideness all sectors, thereby mitigating the risks associated with any one sector’s poor performance. Diversification is the only self-ruling lunch in investing. Don’t skip it.
Dividend focused funds tend to be highly well-matured in US stocks. The Vanguard Dividend Growth fund is allocated 91% to US equities which is typical of the dividend focused funds that Morningstar ranked highly in 2023. And not having an international exposure can be costly.
For example, US stocks had a negative 0.95% stereotype yearly return from 2000 to 2009. That is a decades-long cumulative loss of roughly 17%. Some refer to that period of time as the United States’ ‘Lost Decade’. Meanwhile, international stocks bested US stocks over the same period by an stereotype of 2.99% annually. We don’t like our clients losing decades, expressly in retirement.
Dividend focused funds tend to be highly well-matured in large stocks which are far increasingly likely to pay dividends. At Abacus, we unquestionably overrepresent small stocks in our vendee portfolios, considering small visitor stocks have had a higher return historically. That return derives from their higher risk. Heightened expected risk has a heightened expected reward. Smallness in market capitalization is a source of higher expected returns that is not misogynist when investing for dividends.
What are the Taxes for Dividend Investing?
Dividend yield is less tax efficient than wanted appreciation. Qualified dividends and wanted gains are taxed at the same rate (20% Federal). But dividends are taxed every time they are received, whereas wanted appreciation is only taxed when you sell. Imagine a tree that grows 10 inches every year. And then every year, two inches are cut off. That is similar to how dividends are taxed. Wanted appreciation is a tree you only trim when you need some wood.
In Exhibit 2 below, two investments have the same rate of return and taxation – the only difference is one is entirely dividends stuff taxed annually and the other entirely long-term wanted gains stuff taxed at the very end. Long-term wanted gains enjoyed a roughly 15% wholesomeness in after-tax returns over 15 years. Time compounds this effect.
Other Dividend Investing Tips to Remember
People often goof to fathom that dividends can be (and have been) cut. Companies sometimes decide to reduce or eliminate their dividends during difficult economic times or due to poor visitor performance. This could lead to significant declines in stock prices, as has happened to many financial and energy firms during economic downturns. In 2020, during the height of the pandemic, global dividends fell by $220 billion – or 12% of total global dividends.
Beyond their outperformance in 2022, dividend stocks are perennially popular despite vestige to the contrary. But why? Perhaps it is easier to conceptualize dividends than to think well-nigh selling shares. One can imagine people lightweight to realize that a stock’s price declines by the word-for-word value of the dividend that has just been paid. Comparing the two examples in Exhibit 3 below, you can see that whether via dividends or via a sale of shares, both paths are mathematically identical.
Staying the Investment Strategy Course
Always remember that the financial printing is selling clicks. They don’t necessarily have your weightier interest at heart. Next time you read or hear anything from the media, take it with a grain of salt. They can hawk any idea that captures eyeballs without having to comply with government oversight or unquestionably stuff subject to a client.
There are any number of investment strategies you will read well-nigh over your lifetime. Whatever you do, don’t switch investment strategies repeatedly. Indecision can convert a suboptimal tideway into an investment train-wreck.
At Abacus, we wield investment principles based on wonk research. This research has a upper stratum of statistical conviction that, when maintained over long periods of time, is expected to be both increasingly unspoiled and provide a higher return than alternatives. Narrowing the range of outcomes over time is what makes our financial modeling so powerful. That is what allows you to be intentional well-nigh your life and financial choices.
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