Before we get our hands dirty, let's clear one important note first: there is existing research that supports the hypothesis that dividend stocks outperform their non-dividend peers in total return over the long run, so it's not necessarily a one or the other situation. I can't attest to the validity of these studies since I'm still in the process of looking through them, but readers should be aware of their existence. It doesn't matter for the purpose of this article, where an argument will be made that it makes sense for certain investors to buy dividend stocks exclusively even if total return is sacrificed.
That said, why does it make sense to look beyond total return? Because when we're evaluating the attractiveness of a potential investment, return is only one side of the equation: the other is risk. Volatility and risk may not be easily quantified into tangible values, but they're a real expense for investors all the same, one that must be compensated for by higher expected return. Conversely, if that expense is peeled back by investment vehicles with dampened volatility, it makes sense for investors to trade in return in exchange. After all, one of the founding principles of Warren Buffett's Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B), as outlined in the Owner's Manual, is to "never trade in a good night's sleep for a few extra percentage points of return."
Total return is a pretty academic construct, one that is oftentimes useful, but sometimes the practical realities of life diminish its relevance to individual investors who are putting real money on the line. Imagine this scenario: you're 65 and newly retired, with a sizable nest egg that you've spent a lifetime assembling in preparation for your golden years. I come up to you and make you an offer: I'll flip a coin, and if it lands heads, I'll double your net worth and add in $10 extra from my own pocket. If it lands tails, you lose everything. From a total return, ideal world perspective, you should take the deal, because it makes sense from a mathematical standpoint. For real life investors, it would be complete and utter folly.
There are many valuable products that we buy in everyday life that don't make sense from a total return analysis. Insurance is a big one. Insurance companies are profitable because, on the whole, more money goes into the industry than gets paid out for claims (I'm aware that most insurance companies operate at an underwriting loss, but I'm including investment income in this equation since you can easily invest money you save from forsaking insurance). That means that most people shouldn't be buying insurance if they wished to maximize their "total return." After all, the probabilities state that you're probably not going to need it, and if you do, the payout likely won't be as large as all the premiums you've paid to the insurance company over the years. But people still buy insurance, because hedging against a catastrophic loss is worth skimming some return off the top.
The same principle applies to stock picking. It's all well and good to tell people not to invest money that they can't afford to lose, and generally this is good advice, but for many people, most notably retirees, this doesn't apply. When you're retired and no longer have a job and employment income to fall back on, it is absolutely unacceptable to run the risk of seeing your savings go up in smoke. For younger investors, time is their hedge, because real life results tend to converge with statistical probability over a long enough time horizon. As you get older, time as a hedge becomes less and less reliable. We've all heard the simple formula of keeping 100 minus your age invested in stocks, with the remainder invested in bonds. This advice is grounded in the reality that as you age, dampening risk becomes much more important a concern.
What does all this have to do with dividend stocks? For starters, investing in a lot of the top tier, battle hardened dividend players like Altria (NYSE:MO), Procter & Gamble (NYSE:PG), and Johnson & Johnson (NYSE:JNJ) is even safer than buying the bonds of many lesser companies, and in the current interest rate environment, could net you a superior yield to boot. These companies have survived through recessions, wars, political disruptions, and more, all the while continuing to reward shareholders with increasing dividend payments.
Dividend stocks in general tend to be much more low risk investments than non-dividend stocks. While you're not completely protected from mismanagement, dividends do insulate you to a degree from poor capital allocation decisions by management, giving you a margin of safety equal to the payout ratio. After all, management can't waste money that it has already paid out to owners. Of course, you want your companies to be helmed by great managers in the first place, but we all make mistakes from time to time, and taking measures to diminish the costs of those mistakes can be a very appropriate strategy.
Setting up your portfolio in a manner that allows your living expenses to be supported by your dividend payments protects you from extended periods of market irrationality, which is especially relevant for retirees. It's a fact of life that markets go up and markets go down, but a retiree's living expenses usually only go up, so the problem is evident. Many people point to the 2000s as an example of why it's unwise to rely on capital gains, but the lost decade wasn't actually that bad. Anyone who retired in 2000 benefitted from the greatest bull market run in history in the preceding years, which made up for the flat line ... the compounded annual growth rate for the 20 year period from 1991-2010 was 9%, in line with the historical average.
The bear traps investors really have to watch out for are decades like 1975-1985, where the market moved sideways due to persistent undervaluation, rather than overvaluation. In such an environment, if you're forced to sell stock to pay your expenses, you're unloading your assets at below their intrinsic value. An income stream prevents older investors from having to cannibalize their portfolios at inopportune times in order to fund their retirement. For a much more in-depth look at how dividend investing relates to retirement planning, check out David Van Knapp's excellent two-part series on Mr. and Mrs. Income.
Dividend payers also tend to be more mature companies that are the leaders of their industries, or what Benjamin Graham referred to as primary stocks. There are some companies, like Wal-Mart (NYSE:WMT), that began paying dividends as early as their IPO, but most smaller companies choose to reinvest all of their earnings in order to fuel growth. When you're a big company, you have the financial muscle to withstand the forces of competitive destruction that sink smaller companies every day. You're also protected from economic disruption, because chances are good that if your underlying business is disrupted by a new innovation, you've got money in that new product that allows you to benefit from its success. People usually associate Cola-Cola (NYSE:KO) with carbonated soft drinks, but Coke controls more than a dozen brands, from packaged water to sports drinks to fruit juices. If the day ever comes when soda falls out of favor with society, we'll probably still be drinking something made by Coca-Cola.
Not all dividend stocks fit this mold, of course - a large dividend is no proof of a safe investment. Mortgage REITs like Annaly Capital Management (NYSE:NLY) and Chimera Investment Corp (NYSE:CIM) pay out huge dividends to shareholders, yet their earnings are inescapably bound to the interest rate environment and other macroeconomic concerns that are beyond the control of the company. Other dividend companies, like Intel (NASDAQ:INTC) and JPMorgan (NYSE:JPM), operate in industries that are unusually prone to disruption. Still, dividend stocks as a class are, both by definition and in practice, much more secure investments than non-dividend stocks. That in itself makes it a viable strategy to sacrifice total return in order to pursue a dividend-exclusive investment approach, because you're getting something of equal value in exchange: reduced volatility, dampened risk, and peace of mind. Whether or not you actually have to give up total return is another question, and beyond the scope of this article ... but more on that later.
Disclosure: I am long JPM.