Discovering the Dividend Sweet Spot

Personal Money Planning |

By Gary Silverman, CFP®

Dividends. They are one of the most sought-after aspects of stocks for many, especially retirees. The reason is simple: Live on the income, protect the principal. But is this the best way to look at it?

First, let’s discuss my bias. I am a “total return” investor. I rarely care if the money comes by way of interest, dividends, or capital gains. After all, the source of the money is not near as important as the worth of the money.

Yet the idea of living off your dividends is not wrong. There are just a lot of caveats surrounding it. For instance, a company that is paying dividends doesn’t have to raise the dividends each year. They can cut the dividends. They can eliminate the dividends. We saw this during both the current pandemic and the 2008 Financial Crisis.

“Well,” you say, “I’d just sell off the company that stops paying and buy one that is.” Nice idea, but the reason a company cuts its dividend is because things aren’t going very well for them. Because of this, my guess is that when you go to sell it, the price will be down—and you won’t be able to buy as much of a replacement stock as you’d like.

Another issue is that it will take a larger portfolio to supply your needs exclusively through dividends than it will if you rely on total returns. On average, dividend payout is a little more than 2% of the value of a company’s stock. Many experts agree that a balanced total return portfolio can handle a draw rate of a bit under 4% indefinitely. So, to generate the same amount of income you’ll need a bigger dividend-centric portfolio.

And that brings us to a potential problem with a dividend strategy: Lack of diversification. Certain sectors like Utilities, Telecom, Real Estate, and Oil pay high dividends. This attracts folks. But it also leaves out a goodly portion of the global market.

Another area of interest for dividend investors are stocks that pay a very generous dividend. There are a few reasons that dividend exists. First, the company is mature, has little in the way of competition, doesn’t need a lot of money to expand current operation or develop new product lines. They are the proverbial cash cow.

Of course, the company that looks like a cash cow may instead be in a dying industry--which may be one reason they have few competitors.  In addition, they may have no ability to expand, and their  management doesn’t have the foresight to develop alternate products or services.

And lastly the high dividend payers may look high because they were paying a more modest dividend as a percent of the company’s stock value, but the stock price tanked making the dividend look huge. That might not be the kind of company you want (unless you can predict a nice turnaround in its fortunes) as the next thing that might happen is a dividend cut or suspension.

While it may seem that I don’t like dividend paying stocks, the reverse is true. They are a source of income, tend to be a bit less volatile than the average stock, and can give some peace-of-mind to the investor.

They just aren’t a panacea.

Gary Silverman, CFP® is the founder of Personal Money Planning, LLC, a Wichita Falls retirement planning and investment management firm and author of Real World Investing.