Dividends: The Inexorable Seduction

[skyrefuge]

Dividends are dumb.

If you've paid any attention to my posts in the past, you'll be aware that I'm one of the people most-active in spreading the message that dividends are dumb. Well, that's really an exaggeration; dividends are not actually dumb, they're an important part of investment returns and have many positive aspects. What is dumb is a dividend-focused strategy, and when an investing newbie shows up here pursuing or promoting such a strategy, I attempt to steer them away from it. A well-diversified passive dividend-focused strategy may not even be too sub-optimal vs. a total-return strategy that ignores dividends, but generally the pursuit of such a strategy is an indication that an investor has only a first-order understanding of dividends and stock markets, and I figure a clearer understanding (such as the basic fact that a dividend payment reduces the share price) will be beneficial to their investment success in the long run. So I tend to encourage people to ignore dividends.

All that said, I am here to report for the first time ever, my yearly income from dividends (and interest and passive capital gains) has exceeded my expenses.

And this is very exciting to me.  AUUUUGGGHHHHHH!!!!

This must be what a priest feels like when he walks past a Victoria's Secret, or a new vegetarian when she smells a sizzling steak.  "NOOOOOOOO!! StopItStopItStopItStopIt!!!"

As someone who has no particular interest in dividends, how am I even aware of this situation? Well, maybe it's because I regularly look at a saved report I have in Quicken that tracks my yearly dividend income. Oops. And maybe because this morning I looked up the year-end dividend-per-share amounts just published for my Vanguard funds, and since the total dollar amounts won't post to my account for a couple more days, I hand-calculated the payout amounts!! What the hell am I doing?!?!

To be clear, I have never (and will never) follow a dividend-focused strategy. All my dividends, interest, and capital gains come from passively-managed broad-based index funds. The overall yield on my portfolio is right around 2%. It's income my higher-level brain would actually prefer not to have. Much of it is sheltered from taxation, which makes it a bit more tolerable, but that further highlights the silliness of my excitement, since that "income" is not directly available to pay my expenses anyway.

So, I think the point of all this is to say: I understand. If a sexy dividend standing in a window can excite even me, who is above such simplistic and base desires, I understand how they can be an irresistible draw to less-stoic investors. Clearly the payment of a dividend tickles something deep in our psychology, and is something that our emotional monkey-brains can understand and value more easily than stock-price appreciation.

But don't worry. This doesn't mean I will be giving a pass to dividend-focused strategies; I might even fight more strongly against them, now knowing how deep-seated the desire is. I similarly won't be approving the "eat chocolate-covered bratwurst for every meal" strategy, or the "shoot up heroin whenever you like" strategy. Those things also tickle our lower-level brain functions, but we aren't monkeys. We have higher-level brain functions, and we need to use them to override our base desires. And perhaps nowhere more than the investing world, where following a path of seduction will usually lead to you waking up in an empty room, naked and handcuffed to the bed.

[RichMoose]

Congratulations! Regardless of whether or not you pursue a dividend strategy, earning more in dividends than what you spend each year is an important psychological achievement. Sell your bonds, you don't that stable cash anymore! ;)

[index]

At least your dividends are coming from a diversified index fund. You can't help that some of the companies you own poorly allocate capital. You get a pass.

The biggest problem with dividends I've seen is when people use a dividend to make an investment decision. Look over in the "day trading" thread, there are "experienced traders" citing a 9% dividend as a reason to buy a stock. You could ask how the dividend is sustained but they will just look at you with a blank look. This is not unique to the members of this forum either. Look what happens to the price of a stock when they cut their dividend!

Here is an example of lemmings following a dividend strategy:

Many MLPs (fossil fuel pipeline and storage providers) are effectively melting ice cubes with depreciating assets that need to be repaired, replaced, and exanded. The MLP companies pay out their cash flow to their stock holders and many do not retain money to maintain their depreciating assets. Many borrow money or offer more shares on the open market to raise funds to service/expand their assets while maintaining their dividend. This continues until they are unable to borrow more money then they cut the dividend. The stock falls and message boards are full of "investors" who are upset they no longer have their dividend or their principle. If the market was truly efficient, these type of companies would slowly wind down as they return capital to their shareholders. Unfortunately for these dividend investors, the inefficient market acts like a game of musical chairs.

Reaching for yield is one on the worst things you can do. Dividends have to come from somewhere. They are either a return OF capital, or return ON capital. The latter is much better, but also means the company you are invested is not able to find an acceptable return on investment for that money. Its easier for a company to grow $10 by 20% than $20 by 20%.

The argument for reinvesting your dividends fails as well. Why would you possibly want the company you have invested in to say: "I can't find a suitable investment for this money, here government- take 40%, here investor- this is whats left over (don't forget to pay the government too!). " Your reinvested dividend is half of what the company could have reinvested on your behalf. Its ironic that on a message board urging people to make sure and get their 401k match that the same people are willing to give the government 40-50% of their investment proceeds by pursuing a dividend strategy! 

[Grog]

It 's quite easy to find online guide for the"Ultimate Dividend Strategy MaxiIncome" and co., but I struggle to find a good guide to appreciating stocks, that never distribute dividends. Are there ETF like that? I know Warren Buffett and Berkshire do not distribute dividends....maybe can be considered a similar fund?

[Fallenour]

It 's quite easy to find online guide for the"Ultimate Dividend Strategy MaxiIncome" and co., but I struggle to find a good guide to appreciating stocks, that never distribute dividends. Are there ETF like that? I know Warren Buffett and Berkshire do not distribute dividends....maybe can be considered a similar fund?

In order to fully understand how far, and how well, a stock will appreciate, and Im sure skyreforge will agree, is you need to have a deep understanding of the business itself, its products, and its success strategy.

I focus my efforts of stock appreciating on products and services tied to companies specifically in the tech industry, but I have a very deep understanding of the products themselves, how they work, why they work, who will want them and why, how much they cost compared to other products with that company, and competitors, as well as their competitors themselves.

The best way to describe what I do is similar to warren buffet, just not to the extreme, and not damn near every kind of product that exists. I specifically do tech, he does pretty much everything but tech (I dont count IBM).

Don't try to drive major plays, or make massive bets on stock you dont intimately understand, and never bet on dividends, they really do suck.

Taxes on dividends that actually pay out to you REALLLLY SUCK, have two sets of taxes to run through (your tax bracket, as well as a dividend tax), they dont let the stock increase in value, and arent buying you more stock (The reason I like dividends). Many brokerages these days auto reinvest divis for you so you dont eat massive taxes, but sometimes they dont, and some stock types dont let you (dont ask me, I havent found one yet, but Ive been told that).

In all reality, bets I place most on stocks (for my one offs) are usually mid cap tech companies with a history of good steady market or market+ gains over a solid period of time (more than 2 years) that dont pay dividends. Dividends are more of a turn off than anything else, unless its somehow tax sheltered, I'm looking to keep that stock forever, and use it to cover some of my unique bills (I have a thing for jerky and beer :( )

[arebelspy]

A few miscellaneous thoughts.

First of all, thank you for fighting the good fight in educating people.  Yes, pursuing a dividend only strategy is often detrimental, and many people just don't understand dividends and where they come from and their relation to total returns.

Second, congrats!  That's still a fun, even if mostly meaningless milestone.  :D

Third, I completely get the irrational emotion thing.  I'm about  to hit 1MM, and it's completely meaningless and has no effect whatsoever on my FIRE date, but it's still just fun.

Way to go, skyrefuge, for hitting this mark, and recognizing its arbitrariness.  :)

[index]

In order to fully understand how far, and how well, a stock will appreciate, and Im sure skyreforge will agree, is you need to have a deep understanding of the business itself, its products, and its success strategy.

I don't think he was asking about analyzing companies... 

Taxes on dividends that actually pay out to you REALLLLY SUCK, have two sets of taxes to run through (your tax bracket, as well as a dividend tax), they dont let the stock increase in value, and arent buying you more stock (The reason I like dividends) Many brokerages these days auto reinvest divis for you so you dont eat massive taxes, but sometimes they dont, and some stock types dont let you (dont ask me, I havent found one yet, but Ive been told that). .

Huh? Do you have a brokerage account? You pay taxes on dividends regardless if they are reinvested through a DRIP. The only way to avoid taxes is if the dividend is paid as stock. All the brokerage is doing is buying shares on your behalf with cash received from dividends. Your partial shares are actually accounted for by the brokerage. If you have a large enough account, the brokerage will withhold taxes from your dividends prior to reinvestment.

The best way to describe what I do is similar to warren buffet, just not to the extreme, and not damn near every kind of product that exists. I specifically do tech, he does pretty much everything but tech (I dont count IBM).

You are very similar to Buffett... I'm sure he doesn't understand taxes either...

It 's quite easy to find online guide for the"Ultimate Dividend Strategy MaxiIncome" and co., but I struggle to find a good guide to appreciating stocks, that never distribute dividends. Are there ETF like that? I know Warren Buffett and Berkshire do not distribute dividends....maybe can be considered a similar fund?

Grog, your not going to find a Vanguard type ETF that doesn't pay dividends. Companies pay dividends to reduce their capital so they don't have to find something to do with it. A good high growth company is investing all of their cash flow back into the business. A dividend signifies that a company cannot compound ALL of its earnings. It's not necessarily a bad thing, but by persuing a dividend strategy, you are saying I only want to invest in companies that cannot compound their earnings. An indexing strategy would be fine and would mix companies at different growth rates together.

The problem comes when people say I'm buying company X for the dividend. This carries over to ETF's when you buy dividend centric ETFs of companies that cannot compound all of their earnings.

Some will say dividend strategies outperform, but this relies on the last 30 years of declining interest rates which make dividends more attractive and more expensive. As an example: If you could buy a 10 year treasury paying 9% and no risk would XOMs current dividend of 3% and long term ROR of 10% look as attractive? Probably not. The market would price XOM to have a significantly higher ROR than 10%.

In the last 30 years the 10 year treasury has fallen from 14% to 2.2%. This makes all equities, especially stable dividend payers much more expensive because the market doesn't need to demand as much of a premium when the risk free rate falls so low. 

[Eric]

But don't worry. This doesn't mean I will be giving a pass to dividend-focused strategies; I might even fight more strongly against them, now knowing how deep-seated the desire is. I similarly won't be approving the "eat chocolate-covered bratwurst for every meal" strategy, or the "shoot up heroin whenever you like" strategy. Those things also tickle our lower-level brain functions, but we aren't monkeys. We have higher-level brain functions, and we need to use them to override our base desires. And perhaps nowhere more than the investing world, where following a path of seduction will usually lead to you waking up in an empty room, naked and handcuffed to the bed.

Don't forget the pounding headache!

Excellent post skyrefuge!  And congrats!

[josstache]

For another way to look at it -

Even if dividends were paid out, in the aggregate, as part of a perfectly efficient market, dividends are a comparatively better deal for shareholders that don't pay taxes (pension funds etc), which means they are a comparatively worse deal for shareholders that do pay taxes on them.  So, if we assume part of the reason dividends are paid out as they are is to get money to untaxed shareholders, taxed shareholders should be suspicious that they're getting a bad deal.

Similarly, I believe it has been shown that the tax advantage of municipal bonds means they offer slightly above above-market interest rates for holders in the highest tax bracket, while offering below-market interest rates for anyone not in the highest tax bracket.

[divinvestor]

First of all I want to say, congratulations to skyrefuge! That is an awesome accomplishment. And I agree that a strategy of passive index funds is best for 99% of investors out there. However, I think your hatred of dividends is a bit over the top, over-generalized, and dismissive of those who have had success with the strategy in the past. Firstly, not all dividend-focused strategies are the same. Someone might like buying dividends with really high yields, like 7% and above. While that yield may seem attractive, it's most likely not sustainable in the long run. Another person might like to buy dividend stocks that have a low starting yield, and regularly grow the dividend by a relatively high percentage. This is much more sustainable. And third, someone might focus on buying dividend stocks from the Dividend Aristocrat list, made up of companies that have increased their dividends at least 25 years straight. The latter is the most ideal dividend strategy, preferable if that investor has a diversified portfolio of these stocks. However, this is still somewhat trying to be a stock picker and market timer, which 99% of people out there aren't very good at, and brings us back to investing in index funds as the way to go.

@Fallenour: You must either be a troll, a supreme bullshitter, or just plain don't know what you're talking about. Just for clarity, dividends are taxed from 0% - 20%, based on your ordinary income tax bracket, since 2003.  I have no idea what you mean when you say have two sets of taxes to run through, your tax bracket as well as a dividend tax. Again, your tax rate on dividends is entirely based on your ordinary income tax bracket. There aren't two layers of taxes on dividends. As for your keen interest in mid-cap tech companies, that kind of strategy will probably result in sub-par returns in the long run. Tech companies are much riskier, in the long run, than the consumer staples or healthcare sectors for example.

[brooklynguy]

If you've paid any attention to my posts in the past, you'll be aware that I'm one of the people most-active in spreading the message that dividends are dumb.

...

The overall yield on my portfolio is right around 2%.

I tend to pay very close attention to your posts, because they are among those on these boards most deserving of such attention.

And I can therefore only assume that this post is a thinly-veiled cry for help.  You are suffering from a severe and extended case of OMY syndrome!  You can now cover your annual expenses using a 2% withdrawal rate and yet you are still working!!!  Not only is your monkey-brain deluding you into succumbing to the temptation of a preference for dividends, but it is also preventing you from pulling the trigger on your overdue FIRE.

We need to stage an intervention.