Dividends Matter, But Not For The Reason You Think

by: Sconnie Warrior


Modern Portfolio Theory ignores dividends as merely a component of total returns.

DGI holds dividends are the key component of returns.

Both are imprecise because while dividends matter, it is because they face different risks than non-payers, providing for diversification.

There are a number of articles flowing through Seeking Alpha right now that largely relate to the relevance of dividends. We have ardent total return supporters, ardent dividend growth investors and people who accept both concepts based on personal preference. My biggest complaint with all of these conflicting pieces of opinion is they are really addressing a question of individual style, goals and yes, individual philosophy.

David Van Knapp hit on this question in his article. But I would like to redirect his thesis somewhat. The central counterpoint I have not seen adequately broached in these discussions is the question of risk adjusted value.

One quote from Dale Roberts' article may seem like a truism in the investment community:

But for those who are newer investors or those exploring dividend growth, a few of us on SA like to make them aware of the true gift of dividend growth -- greater total return. And make no mistake, whoever has the most money wins. Period.

This statement is fundamentally flawed (even leaving out how crazy it would make most moral philosophers). On its face it presents the idea that the one with the most money wins, which misses an important corollary. The true winner is the one who has successfully sought (and found) Alpha. Is the one who has the best risk-adjusted return on their money. Few would agree to the concept that an investor should take whatever risks necessary to become as rich as possible, as this fails to take full account of risk and the opportunity costs of investing purely for maximum returns. There are numerous investors that have great luck, and make a lot of money by adopting massive levels of risk. This can be seen across all investment philosophies. (I am sure Dale would agree with me on this point, and I am being somewhat hyperbolic here for the sake of discussion, but it presented a very invigorating point of contention, which I sought to explore, so thank you, Dale).

A few examples of this that come to mind are investors that seek excessive yield companies like mREITS, penny stocks, junk bonds, or those who over-allocate to certain investment classes like gold.

We have all seen someone take a tragic fall after getting cocky or wound-up in one investment philosophy. To me, this fits into a simple investing idea, which is risk management.

The first step on any investment path is to determine your needs and goals as an investor. If you are investing for retirement or income replacement, you must then address timeframe, risk appetite, and a host of other factors to make your decision. Once you have done this, you ought to make a plan that accomplishes your goal, with a satisfactory amount of risk.

The basic tool investors have to provide risk management is diversification. Diversification in its simplest form is owning enough different (non-correlated) assets that the failure of one part of your portfolio will not severely hamper your entire portfolio -- the old adage, don't put all of your eggs in one basket.

There are a number of ways to achieve diversification, you can allocate a balance of asset types buying index funds of stocks, as well as a component of bonds, as well as commodities and other counter-cyclical assets. This is becoming the norm for most retirement and financial planning scenarios, and indexing does work very well, and is especially potent for financially unsophisticated investors, or those who want security with minimal effort and cost.

There are also methods that attempt to improve on indexing. These can range the gamut from day-trading and buying speculative investments to those who merely try to improve on indexing by purchasing specific stocks at fair valuations. I see DGI investors as falling into the second bucket. They have found a universe of stocks that appeal to them -- often the dividend aristocrats or the dividend champions -- and they purchase stocks that they like due to valuation, economic moat or any number of individually persuasive metrics.

Eli Inkrot provided a very interesting article that considered basing a dividend income portfolio (in-part) on timing of payouts. It was definitely a novel and thought-provoking idea that addresses a likely need of a large segment of the population, to wit immediate and consistent income.

For me, dividends are helpful, because they help me to value a company. When I have a known cash flow, and can predict or calculate the total return component made up of dividends, it can help me to determine which stocks trade at a value and which are overbought. I am also able to utilize dividends to increase my basis and provide downside risk should a stock become worthless or suffer a large fall in share price. Dividends also provide cash flow to be used in the purchase of new securities. But more important than all of that, they provide risk diversification.

Market forces, famously called animal spirits by John Maynard Keynes, are often (or always) difficult to predict, and can provide for massive short-term variation. This basic component of market risk proves the necessity for good diversification, especially for investors who are living off of investment portfolios.

Likewise, dividends can be cut or eliminated. This is my biggest concern for dividend growth investors, who often seem to be allocated largely, or entirely, to equities that pay dividends. While this might be effective in many cases, a dividend cut can drastically effect share price, leaving a retired DGI investor holding the bag.

To avoid these risks I find it prudent for every investor, regardless of philosophy, to have some alternative assets and plan should the nature of the game change. Bonds have legally required coupon payments, alternative assets can perform well above the market especially in prolonged downturns, real estate, insurance, and even cash can all outperform and provide some downside protection for the unknown.

I think it is time for all of us investors to re-evaluate our own portfolios and consider that perhaps too much of a good thing might be leaving us blind to a potential hazard.

Disclosure: The author is long SPY, GLD. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.