Dividend Investing – The Ultimate Cash Trap?

This week we’re going to spend some time evaluating an investing strategy that has become popular amongst millennial crowds over the last decade or so, called “Dividend Growth Investing.” Surely, you are familiar with dividends, the small payments that are automatically deposited into your brokerage account quarterly, as companies like Coca-Cola (KO), Microsoft (MSFT), and Disney (DIS) return excess profits to you, the shareholder. The dividend growth investing strategy is built around these payments and contends that if overtime, you invest your money in companies that continually pay dividends, and that the amount of those dividends continues to increase each year, you will eventually amass a portfolio that generates enough income to support you in retirement. On its own, this sounds amazing, right? Buy some shares now, and let them pay you for continuing to hold them. After all, at the end of the day, your ultimate financial goal should be to first determine the amount of income that you will need to live the lifestyle that you want, determine how to generate that income, then not spend a day more than you must, working towards that goal. Dividend investing seems to be a way to accomplish the second step. But, as great as dividend investing may seem initially, there’s a catch, and you’ll learn just what that is in the sections to follow.

The Case for Dividend Growth Investing

First, let me start by saying that dividend investing, or dividend growth investing, isn’t bad. In fact, this strategy can yield amazing results if used properly and it fits your particular investing needs. I’m just going to venture a guess that this isn’t going to be the case for most readers.

To illustrate the appeal of dividend growth investing, consider the following. Through a thorough analysis of your lifestyle, and future goals, you’ve determined that you will need approximately $200,000 a year in retirement to live the lifestyle that you would like. As noted in the section above, your next step is to determine how you’ll get there, and we’re going to assume that you’ve decided to employ a dividend growth investing strategy. You decide to target the following 5 companies, IBM, Coca-Cola, 3M, Disney, and Qualcomm, each yielding an annual dividend of $1/per share or greater. You could focus on the dividend yield for comparison purposes if you’d like, but that can be manipulated by price swings, and ultimately, at the end of the day you can’t go on vacation, pay tuition, or buy a yacht with “yield.” You need cash! Now that we’ve selected our portfolio, let’s see how much it will cost to build a portfolio that will generate the $200,000 each year that we’re hoping to receive:

To build a portfolio today that yields $200,000 per year in dividend income could cost $6 million dollars, or more. Similarly, if we assume that 5 or 10 years ago we knew that these companies would yield these dividends, we could have built our portfolio for about $4.9 million or $3.3 million, respectively. Still, each of these scenarios requires a huge initial outlay of capital (or you can work to slowly acquire the shares in chunks, over time). For most, this will prove problematic.

Despite the huge initial outlay that is required to make this strategy work, it does have some advantages. One is simplicity. You do not need to be an excellent stock picker to make this strategy work. Simply google “best dividend paying stocks” and see what pops up. You’re sure to get the names in the chart above, as well as others like Apple, Pepsi, and Starbucks. Pick your favorite 5 – 15 and get started buying as many shares of these companies as you can. Each quarter dividends will be deposited into your account, which can be set to automatically re-invest in those same companies using a dividend reinvestment plan, or “DRIP” or you can collect the cash and use it to purchase shares in other companies.

Additionally, to make this strategy work, you only need to know how much annual income you’ll need in retirement and some elementary math. For the most part, the future dividend payments that these companies will make are already decided. Just take the last annual dividend payout and grow it by about 3% – 5% each year to determine the amount that you will receive the following year, and every year after that. Simply divide your income goal by the dividend assumption, and you’ll arrive at the number of shares needed to generate your desired income. Other advantages include the ability to generate income while holding less risky shares and having a predictable passive income stream.

The Case Against Dividend Growth Investing

For all its simplicity, the dividend growth strategy leaves a lot to be desired for most. Recall in the situation above, that to construct the portfolio that we want, we’d need to either invest about $6.2, $4.9, or $3.3 million dollars. In a vacuum, that would be fine, but we haven’t considered what we would have to give up, or the opportunity cost of making such an investment. In this case we are forfeiting the ability to invest in riskier, but faster growing companies that have massive capital gains appreciation potential. Take a look at the returns that would have been generated given the same amount of capital used to build our dividend portfolio had it been invested evenly across the FAANG stocks over the same period.

Most money managers will tell their clients that they should outlive their money if they withdraw 4%, or less, annually from their nest egg. But let’s take a more conservative approach, and assume that we’ll only withdraw 2% of the amount that we have saved. How would we fare? Well, 2% of $26.6 million is about half a million dollars, while 2% of $80 million is about $1.6 million. Under either scenario, we’d have significantly more walking around money than the $200,000 that we would receive from our dividend portfolio. That said, this assumes that you knew to invest in these companies long ago, a task much easier said than done. Keep in mind that these companies were much riskier 5 or 10 years ago than they are today.

This brings me to my next point; dividend growth investing can give investors a false sense of security as they tend to be less concerned with day to day stock price changes and hyper-focused on changes in dividend payments. Dividend investors should keep in mind that while the companies that they typically invest in carry less risk than those that do not pay dividends, there are still plenty of stock paying companies that have gone bankrupt or have otherwise struggled and been gobbled up by larger companies or taken private by its owners or private equity.

Finally, it is important to consider the current economic environment. The Fed has already stated that it intends to raise interest rates through this year and likely into the next as well. When interest rates rise, dividend-paying stocks tend to underperform their peers due to a combination of investors being risk-averse, and opportunity costs. If the rate on the risk-free treasury rises to 4%, or equal to some dividend-paying stocks, investors in those companies will likely sell their shares and instead hold the treasury which has the same yield but is risk-free. As a result of investors selling off their dividend-paying stocks, the price falls, until eventually, the dividend yield is high enough to entice new investors.

Summary

Dividend stocks serve a purpose and can be an important component of a portfolio. That said, for younger investors that still have 20+ years until they plan to retire, dividend investing probably isn’t going to be your best bet. Instead, look to build a substantial nest egg by owning shares in companies with the potential to grow quickly and return multiples of your investment.

By paying a dividend, a company is admitting that they can’t offer you a way to grow your money any faster than their dividend yield of 3% -5%. So why give that money back to them? If you still feel the need to generate “income,” consider diversifying into real estate. This way you’ll have a more diversified portfolio of assets should equities take a beating. You will also likely benefit from the long-term asset appreciation, in addition to the rental income your properties generate as well. Sure, dividend stocks can appreciate as well, but it isn’t uncommon for them to remain stagnant, or lose value either. Finally, while dividend growth investing can definitely lead to a great retirement, for most of us, it would simply take far too long to achieve our financial goals. Personally, I’m hoping to be able to retire well before 50, and the sooner the better. My plan doesn’t leave a ton of time to slowly accumulate dividend stocks year after year. Instead, I’ll be on the lookout for the next group of undervalued, high growth stocks to add to my portfolio.

Let us know your thoughts on this investing strategy, in the comments section, below.