By Taylor Schulte | Financial News
The allure of dividend investing is worse than smoke and mirrors; it’s downright propaganda. Regardless of whether dividend investing has been trending lately, it’s not the foolproof retirement answer it’s made out to be. Here’s why:
Problem No. 1: Historic performance
Cash dividends sound great, but is the proof in the pudding? Unfortunately, all signs point to “no” since dividends fail the historic performance test.
A mountain of investment data exists to show how and why investing makes sense. Stocks, for example, have generated investment over-and-above inflation. Further, stocks of small companies have provided even better returns.
There are many investing strategies — including value investing, investing to focus on shareholder yield, or investing in companies with a low dividend payout ratio. Historically, these strategies all tend to do better than traditional dividend investing over long periods of time.
Remember, there are three keys to becoming a successful investor. Those keys are keeping investment costs low, diversifying your investments broadly and not chasing performance. These three key factors don’t really jive with dividend investing strategy — bringing us to problems No. 2 and No. 3.
Problem No. 2: Cost
On average, keeping your investment costs low is the key to scoring the best investment return. When you pay less to invest, you keep more money for yourself. The math is pretty simple.
People who focus on dividend investing tend to ignore ongoing costs. A dividend-centered investment fund (a mutual fund or an ETF) is almost always more expensive than a broader, more-diversified fund. Let’s use these two examples as a basis for this argument:
iShares Core S&P total U.S. Stock Market ETF expense ratio: 0.03 percent
iShares select dividend ETF expense ratio: 0.39 percent
Look at the two funds above and you’ll notice the dividend fund costs 13 times as much as the broader, more diversified fund. And this comparison assumes you’re buying low-cost funds to begin with. Obviously, the price difference might be even worse if you’re opting for the expensive active-management route.
Believe it or not, you could be paying up to 36 times (or more) for a dividend-focused fund compared to a low-cost broadly diversified index fund.
Over time, these added costs will chip away at your earnings. So, you may be receiving dividends, but you’re paying a lot more money out than those dividends are worth.
Problem No. 3: Diversification
The value of diversification is so ubiquitous that I’m sure you’ve heard this before. Still, it bears repeating that you should never put all of your eggs in one basket.
When you focus your investments on those companies that pay dividends, you’re doing the opposite of diversification: You’re concentrating your investments into just one type of company. This makes your investments riskier.
So, if you think dividend investing is a safe strategy, I would caution you. Focusing on dividends can be very risky. Let’s not forget that it was the very same euphoria for dividend-paying companies that caused a stock market bubble and poor stock market performance of the 1970s.
The bottom line: Invest smarter and ignore the trends
When it comes to being a smart investor, you don’t need to become a rocket scientist. To get the best returns over time, you need to focus on the three pillars of smart and profitable investing — keeping costs low, diversifying your investments and not chasing performance.
While dividend investing might be all the rage these days, it fails all of these tests. Not only has it underperformed other strategies historically, but it comes with a tax drag to boot. Worse, dividend investing can be extremely expensive.
Skip dividend investing for proven, low-cost, diversified investments instead and you’ll be a lot better off in the end.
See an expanded version of this article on sandiegodowntownnews.com.
—Taylor Schulte, CFP® is the founder of Define Financial, a fee-only firm in Downtown San Diego. He is passionate about helping clients accumulate wealth and plan for retirement, and can be reached at 619-577-4002 or firstname.lastname@example.org.