In my last two videos I talked about high
yield bonds and preferred shares. These are two alternative asset classes that
investors venture into when they are seeking higher income yields. I told you why you might want to avoid those
asset classes. Today I want to tell you why focusing on investing
to generate income is a flawed strategy altogether, and why a total return approach to investing
will lead to a more reliable outcome. Investors often desire cash flow from their
investments. There are blogs, books, newsletters, and YouTube
channels dedicated to income investing. Income investing means building a portfolio
of dividend paying common stocks, preferred stocks, and bonds in an effort to generate
sufficient income to maintain a desired lifestyle. The idea is that if you have enough income-paying
securities in your portfolio, you will be insulated from market turbulence and can comfortably
spend your dividends and coupon payments regardless of the changing value of your portfolio. There is a perception that if you never touch
your principal, you won’t run out of money. It seems like a fool-proof retirement plan. But is it, really? I’m Ben Felix, Associate Portfolio Manager
at PWL Capital. In this episode of Common Sense Investing,
I’m going to tell you why income investing will not give you more income. This video is in response to a question from
Joey, who contacted me by e-mail. Let me start off by saying that there is no
evidence that dividend paying stocks are inherently better investments than non-dividend paying
stocks. There are five factors that explain the majority
of stock returns. Dividends are not one of these factors. For example, we know that if you gather up
all of the small cap stocks in the market, they will have had higher long-term returns
than all of the large cap stocks in the market. Based on this, company size is one of the
factors that explains stock returns. The same evidence does not exist for dividend
paying stocks. If they aren’t better inherently investments,
why do people like them so much? In a 1984 paper, Meir Statman and Hersh Shefrin
offered some potential explanations for investors’ preference for dividends. If they have poor self control, and are unable
to control spending, then a cash flow approach creates a spending limit – they will only
spend income and not touch capital. Another explanation offered in the paper is
that people suffer from loss aversion. If their stocks have gone down in value they
will feel uncomfortable selling to generate income. On the other hand, they will happily spend
a dividend regardless of the value of their shares. There’s a problem. As much as a dividend may seem like free money,
the reality is that the payment of a dividend decreases the value of your stock. If a company pays twenty million dollars to
its shareholders as a dividend, the remaining value of the company has to decrease by twenty
million dollars. The investor is no better or worse off whether
the company that they invest in pays a dividend or not. This is known as the dividend irrelevance
theory, which originated in a 1961 paper by Merton Miller and Frank Modigliani. I have just told you that whether returns
come from dividends or growth does not make a difference to the investor, but there is
an important detail for taxable investors. There is no difference whether returns come
from dividends or growth on a pre-tax basis. On an after-tax basis, the investor without
the dividend is in a better position because they could choose to defer their tax liability
by not selling any shares if they don’t need to cover any spending. The dividend investor is paying tax whether
they spend their dividend or not. This is a big problem for an investor who
does not need any income at that time. About 60% of US stocks and 40% of international
stocks don’t pay dividends at all. Investing only in the stocks that do pay dividends
automatically results in significantly reduced diversification. Dividend investing can also lead to ignoring
important parts of the market. There are plenty of great companies that do
not pay dividends. Ignoring them because they do not pay a dividend,
which we now understand is irrelevant to returns, is not logical. A good example of this is small cap stocks. An income-focused investment strategy will
almost certainly exclude small cap stocks, few of which pay dividends. Now, don’t get me wrong, dividends are an
extremely important part of investing. One dollar invested in the S&P/TSX Composite
Price Only Index, so excluding dividends, in 1969 would be worth $14.37 today. The same dollar invested in the S&P/TSX Composite
Index, which includes dividends, would be worth $64.59. If you are investing in Canadian dividend
paying companies, you also receive favorable tax treatment on your dividend income. Dividend paying common stocks are an important
part of your portfolio, but a dividend-focused portfolio leads to tax-inefficiency for taxable
investors, poor diversification, and missed opportunities. A total-return approach, accomplished by investing
in a globally diversified portfolio of total market index funds, results in greater tax
efficiency, better diversification, and the ability to capture the returns that the market
has to offer. The topic of dividends tends to get people
very excited. Dividend investing is almost more of a lifestyle
than an investment philosophy. I would be happy to hear your thoughts in
the comments. Join me in my next video where I will tell
you why active fund managers don’t protect you in down markets. My name is Ben Felix of PWL Capital and this
is Common Sense Investing. I’ll be talking about a lot more common
sense investing topics in this series, so subscribe and click the bell for updates. I want these videos to help you to make smarter
investment decisions, so feel free to send me any topics that you would like me to cover.