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Recently Fidelity Investments had a link on its home page to a Money Magazine article by Walter Updegrave titled "Living Off Dividend Income"(here, original at this site). Updegrave's article was framed as a response to a reader's inquiry about how to invest his portfolio so he could live off dividend income in his retirement.

In the article Updegrave tries to persuade readers not to try to live off dividend income, since a narrow focus on dividend-paying stocks may produce a poorly diversified portfolio. He notes that Vanguard's Dividend Appreciation ETF (NYSEARCA:VIG) has more than 50% of its assets in two sectors, industrials and consumer stocks, and quotes a Dartmouth finance professor as saying, "If you buy only high-yield stocks, the sacrifice in diversification is huge."

Instead Updegrave suggests that investors buy a mix of stocks and bonds using index funds to make sure they are well diversified and collect what should amount to about 2% in interest and dividends. If they need to supplement that 2% with more income, they should do so by "creating homemade dividends" by selling shares to make up the difference. "Selling shares," he says,"lets you control how much money you'll get from your nest egg and when." If you rely on dividends, he asserts, "you're tying your cash flow to a corporate policy decision that has nothing to do with your needs."

Updegrave calls the goal of living off dividend income "the dividend illusion." "You might think," he says, "that by living off dividend payments you're avoiding the 'sin' of dipping into capital. But that's just an illusion."

Updegrave may be right about the diversification issue, but the way he represents dividends in his article seems biased at best and deliberately deceptive at worst. In trying to steer inexperienced investors away from an overconcentration on dividend stocks, he seems to misrepresent how dividends work.

Here's his example:

"If you invest, say, $100,000 in 1,000 shares of a stock that sells for $100 and pays a 50¢-a-share quarterly dividend, you would still have your original hundred grand (assuming the stock didn't move for any other reason), except that you'd end up with $500 in cash and $99,500 in stock. Spend that $500, and you've essentially dipped into your capital."

In essence, Updegrave is representing the ex-dividend price drop of a stock as a permanent loss of capital. What he leaves out is the effect of the expectation of future dividends on investor behavior, and that's where the possible deception comes in.

It's true, of course, that the $100 stock will initially trade ex-dividend at $99.50, meaning that the shares will only be worth $99,500. Add in the $500 dividend, and the total is still $100,000. Of course, in reality the stock price will trade higher or lower than $99.50 as traders buy and sell based on their perceptions of where the market is headed, how the stock's sector is doing, and what the company's future prospects are.

But here's what Updegrave neglects to say, perhaps deliberately. If the company has paid a 50-cent dividend every quarter for the last ten years, has sufficient earnings to cover the dividend, a low payout ratio, and a wide moat to protect its business, then it will most likely pay the same dividend again in three months' time. Knowing that, traders will bid the stock's price back up to $100 in order to capture the dividend. That's because as soon as the company announces the next 50-cent dividend, the stock will be worth $99,500 plus the anticipated $500 dividend or $100,000. A simplified, highly schematic diagram may help make this clear.


(Click to enlarge)

If course, this diagram doesn't take into account the numerous sources of volatility that will move the stock's price up and down and make it highly unlikely that the stock will be worth exactly $100 three months later. But abstracting out all the "noise" is meant to make the point that anticipation of the next dividend provides an upward bias to the stock's price and means that Updegrave's statement that "you've essentially dipped into capital" is potentially misleading.

Now, suppose that the company raises its dividend by 10% to 55 cents per share. All other things being equal (which they aren't), the stock's price will rise as investors move to capture the extra yield in both the next quarter and future quarters. Instead of a $500 dividend, our investor will now receive $550 each quarter or $2200 instead of $2000 each year. And suppose further that the company continues to raise the dividend by 5 cents a year for the next 10 years. A decade later our investor will collect a $1.00 quarterly dividend, which translates into $4000 per year, all without selling any shares. That's the power of dividend growth investing.

Updegrave may be right that investing solely in dividend growth stocks will produce a badly undiversified portfolio. That's not the issue here. The problem is that he seems to have practiced deception in representing a stock's ex-dividend price as a permanent drop in capital. After all, in his representation, the stock would be worth $99.50 after one quarter, $99.00 after two, and $98.00 at the end of a year. This makes it look like the stock's price will continually fall $2.00 per year and decline straight to zero in fifty years' time. But all things being equal (which they aren't), the anticipation of future dividends will keep the price at about $100, unless the company increases or decreases its dividend. That's why investors eyeing retirement find dividend stocks so attractive.

Disclaimer: I am not a registered investment adviser and do not provide specific investment advice. The information contained herein is for informational purposes only. Nothing in this article should be taken as a solicitation to purchase or sell securities. Before buying or selling any stock you should do your own research and reach your own conclusions.

Source: Demystifying The 'Dividend Illusion'