Rethinking Norms
From time to time in this business, we run across certain ideas that have become so commonly accepted and so pervasive that almost no one questions them anymore. Sometimes, though, these ideas emerged from shaky ground, have outlived their usefulness, or (at least in my view) make very little sense when you investigate them fully.
I do my best to tackle some of these concepts in my “Rethinking Norms” series, and today I’ll address the myth of the “dividend as income source.”
Please note that, as always, nothing in our blog posts should ever be taken as specific investing nor tax advice. There are some distinctions and complexities between, among other things, the tax treatments of the different approaches discussed below. For simplicity, I’ll ignore those for now, and I’ll also intentionally oversimplify the distinction between, for example, ex-dividend dates and dividend payment dates, because they don’t really alter the point. Opinions expressed are those of the author alone.
Dividends and Capital Appreciation: Two Sides of the Same Coin
It's conventional wisdom in financial planning that if you want to generate income from your portfolio (often in retirement), you should load up on dividend-paying stocks. The logic seems sound - companies that pay dividends will provide a regular stream of cash payouts that can supplement other income sources.
However, this long-standing advice overlooks a critical truth: dividends and capital appreciation are not actually distinct concepts, but rather two sides of the same coin. Once you understand how they’re connected, the flawed rationale behind favoring dividend stocks for income generation becomes clear, and the way you look at investing altogether may very well change.
The Mirage of Dividends
Many investors perceive dividends as a tangible form of return, providing a regular stream of income from their investments. On the other hand, capital appreciation/equity growth is often viewed as a more abstract concept, representing the potential growth in the value of an investment over time. This dichotomy can lead to the belief that dividends and capital appreciation are separate and unrelated.
This perception is flawed. Dividends are not a separate source of return; they are simply a distribution of a portion of a company's earnings or retained capital to its shareholders.
Dividends are just a company's way of sharing their profits with shareholders. But here's the thing - when a company pays out dividends, it's reducing the value of the company (and your shares) by that same amount. So, while you're getting cash in your pocket, the overall value of your investment is going down.
In essence, you own a portion of the company “pie”, and the dividend amounts to the company handing you your slice without you asking for it. The pie is smaller now, without your piece in it. But if you own a specific portion of a pie, it doesn’t make much of a difference if someone hands it to you or not. It was yours either way, and neither the amount of pie nor the value of it has changed. You were always free to “cash out” your portion, regardless of whether someone else arbitrarily decided how much and when you should take it away.
Here's a useful way to think about what happens (roughly) when a stock pays a dividend:
Imagine you have 100 shares of stock and the stock trades at $50 (you have $5,000 worth).
The next day, the company hands you a dividend of $1/share (a 2% dividend), which is $100. This feels like income. But here’s the part that many misunderstand because relatively few people talk about – solely by virtue of the dividend being paid, the company has transferred real value directly from within the company to outside of the company, and the stock’s price will be adjusted downward to $49. Nothing fundamental has changed.
You had $5,000, in the form of 100 shares of $50 stock. Now you have $5,000, in the form of $4,900 worth of stock, and $100 worth of cash.
Another way to accomplish the exact same result without a dividend being paid is to simply sell 2% of your stock. In that case, you’d have had 100 shares of $50 stock ($5,000) on day 1, and then 98 shares of $50 stock on day 2 ($4,900), plus $100 in cash (from the 2x $50 shares you just sold). Exactly the same result.
The Dividend Fallacy Leads to a Choice: Dividends or Capital Appreciation
Of course, in the above example, you could have chosen to just keep all 100 shares in the $50 non-dividend paying version of the stock. You’d still have $5,000 worth of value. If the company’s value then grew by 10%, you’d have $5,500, whereas in the dividend paying example, you’d have only ($4,900 x1.10 =) $5,390. If you count the $100 of cash you took out, you’d have $5,490 - still less money, because the $100 wasn’t left in the stock to grow inside the underlying company.
Ultimately, the choice between receiving dividends or capital appreciation is a matter of personal preference, tax considerations, and investment strategy. At the risk of belaboring the point, you could allow more money to grow within a single stock, let it pay a dividend and reinvest that dividend (which to be clear is a bit of an inefficient way of leaving all the money in the stock in the first place), take the dividend and reinvest it elsewhere, or simply sell whatever shares you need to raise cash when you need it, at regular intervals or otherwise.
The main thing to remember is that there is no magic in a dividend. Money doesn’t appear nor disappear; it just gets moved around.
Understand What Matters, What Doesn’t, and What You’re Really Getting Into
Regardless of the method chosen to monetize investments in the end, it’s essential to recognize that these two concepts are not fundamentally different but rather two sides of the same coin. By understanding this relationship, investors can make more informed decisions and avoid the pitfall of overemphasizing one aspect while overlooking the other.
If what you really want is “income” that doesn’t depend on your exposure to company profits and stock performance, you’re probably looking for something else entirely. What happens in either the case of dividend payments or equity growth (and subsequent stock sales to raise cash) isn’t fundamentally different, and in my opinion a lot of talk in the financial planning world glosses over this point by suggesting that dividends are somehow a safer way of taking money out of equity holdings when you need income.
If, for example, you’re bothered by the idea of leaving money invested in a stock, exposed to up and down price movements, and needing to sell it to get cash when you need it – you shouldn’t really feel all that differently about owning the stock and getting paid a dividend. You’re still exposed to the same market forces, and the method of distributing the cash doesn’t change anything fundamental your risk profile or exposure.
So, what kinds of sources would be different?
Given what we’ve discussed, think about income sources that aren’t like this:
- Income from a job (funds leaving employer and coming to you)
- Income from Social Security (funds leaving the government and coming to you)
- Income from a loan you’ve made (interest payments from the borrower to you)
- Income from bonds (interest payments from the borrower to you)
Compare this to “income” sources like a dividend. Dividends are your own assets being repaid to you. If you have $100k in a savings account and pay yourself $1k to checking, you have repurposed the funds and are free to spend them just like a dividend, but you can see how this intuitively is different from what people mean when they say they have “generated income.”
Dividends Aren’t Really a Company Characteristic
Incidentally, I’m not saying there’s nothing fundamentally different or appropriate about the types of companies that tend to pay stable and/or steadily growing dividends. They might very well sometimes have certain factors or characteristics that are well suited to certain portfolios (examples of such “factors” might be profitability, strong balance sheets, strong historical earnings/margins, etc).
A more useful way to think about this, though, is that such factors can be isolated and, if desired, targeted with or without the payment of the dividend playing a role. “Dividend” isn’t really a characteristic of a company, it’s just a means of transferring money from one bucket to another. At best (and only sometimes) it’s just a proxy for other more specific and intentional factors that you’re better off considering directly.
The point is: don't get too hung up on whether a company pays dividends or not. Focus on the overall potential for growth and value creation, and decide which approach works best for your investing goals and timeline. Just know that when it comes to dividends versus capital gains from equity holdings (most often “stocks”), you're really just picking how you want that money served up.
Opinions expressed are those of the author and not necessarily those of Guardian or its subsidiaries.
2024-173562 Exp 04/26