Dividend-Paying Stocks and Other Mental Math Tricks

We hear this one a lot: Preserve your principal and live off of the proceeds in retirement. When interest rates disappoint, this often translates into investing in dividend-paying stocks instead. Unfortunately, while a focus on dividend stocks may be a common denominator found in many retirees’ investment equations, the logic doesn’t quite add up. Let’s go over why this is so, and why there may be better ways to both preserve and enjoy your total wealth.

Money = Money
It’s true that the notion of “principal” versus “interest” versus “dividends” can make for convenient mental accounting when managing your money. The idea of one’s golden goose sitting comfortably in her nest while you enjoy her daily eggs is steeped in a noble tradition. But it’s also true that, no matter how you label it, it’s all just money – your money. While there may be tax and other financial ramifications to consider, it all saves and spends the same way.

Fooling Yourself, At Your Own Expense
When you look at it from this angle, it’s easier to recognize that you are essentially playing a mental accounting trick when you think of some of your money as untouchable principal and some of it as spendable yields. We financial professionals sometimes refer to this as “yield bias.”

Far be it from us to eliminate mental accounting tricks that enhance your investment experience. For example, there is no substantive difference between manually depositing a portion of your paycheck into your investment account versus having it auto-deposited for you. But if the automated solution helps you save more, then by all means that’s what you should be doing.

Unfortunately, dividend stock investing is a mental accounting trick that may feel good at the time, but that can ultimately hamper more than help your aim.

Factoring in the Evidence
Let’s quickly review what the evidence indicates is the best way to build wealth while managing the market risks involved. In so doing, we concentrate on maximizing your money – your investable and spendable assets alike – and minimizing the odds that you’ll go broke along the way. Shouldn’t that be your true goal?

Whether you are investing toward retirement, college funding, lifestyle enrichment or all of the above, the steps toward sound, evidence-based implementation remain essentially the same:

1. Plan – Determine your personal financial goals, timelines and risk tolerance levels and document them in your Investment Policy Statement (IPS).
2. Construct – Guided by your IPS, build a globally diversified portfolio tilted toward or away from asset classes offering particular levels of expected risks and related market returns.
3. Maintain – As near-term pricing swings up and down, stay invested as planned to capture the market’s expected long-term growth (including disciplined rebalancing to sustain your desired risk/reward balance).
4. Assess – As your personal goals shift as you achieve or alter them, reposition your portfolio as warranted to reflect your evolving circumstances ... but do so as efficiently and cost-effectively as possible.

That’s pretty much it. To implement these steps to success, we pay close attention to a number of key factors such as the levels of risk/expected return in your portfolio, tax efficiency, effective diversification, and optimally generating necessary cash flow, regardless of its source.

Investment Apples and Dividend Oranges
In short, whether a stock yields more or less dividend income is a bit of a red herring, in that it’s not a detail that helps us efficiently implement your plans according to your goals. In fact, according to a recent Dimensional Fund Advisor white paper, Yield vs. Total Return, it can detract from these essential efforts. We encourage you to read the paper for additional insights, but its conclusions are clear.

Principal draw-down in disguise – First, the evidence dispels the popular notion that dividends provide an income stream while leaving your principal untouched. In reality, dividends are generated by reducing the stock price. This means, unless you reinvest that dividend back into stock shares, you are still encroaching on principal, just in a different, less obvious way.

Not-so-dependable dividends – Moreover, dividends are neither certain nor guaranteed, as many investors experienced firsthand during the 2008–2009 financial crisis. Just when retirees needed to depend on dividend income the most, many companies reduced them or cut them out.

Taking your eyes off the prize – Finally, biasing your portfolio toward dividend-yielding securities can inadvertently bias it away from optimal pursuit of your personal financial goals, as described above. Dimensional’s report concludes, “Biasing a portfolio toward stocks with higher dividend yields or bonds with increased yields will likely change a portfolio’s risk and return characteristics. Investors should be aware of the related tradeoffs before pursuing a yield bias.”

It can be difficult to admit that a popular asset management adage may not apply as well once you’ve scrutinized it with an objective eye. But by recognizing when a fable is a fable, you stand a better chance of truly living happily ever after. Give us a call if we can help invest your retirement nest egg for effective outcomes.