Debunking Dividend Investing Myths ft. Taylor Schulte (EP.165)

0:28We all need to make smart decisions with our money. the world of dividend investing with Taylor Schulte, who did a fantastic dividend investing series on another Retirement Podcast Network podcast called Stay Wealthy. Together, Taylor and I will debunk some common myths and provide you with a clear understanding of how dividends work. We'll also explore the pitfalls of focusing solely on dividend yield and discuss the importance of considering total return when building your portfolio. I think you'll really enjoy some of the analysis that we have based on the dividend-focused funds compared to the broader market, as well as just going through the tax implications of dividends versus stock buybacks and how to create a sustainable retirement income.

1:12So get ready for an informative, engaging discussion that I am sure will enhance your investment strategy. Now, let's get started.

1:24Taylor Schulte, welcome to The Long-Term Investor. Peter Lazaroff, thank you for having me. I appreciate you coming back on the show. You had such a good series on dividend investing. People can check that out at Stay Wealthy. We're both members of the Retirement Podcast Network. And I think that one of the topics that does come up a lot are these dividend investing misconceptions. I hope that we can dig through some of this. And I will obviously link in the show notes at thelongterminvestor.com all four episodes from your dividend investing series. But why don't we just start with the basics?

1:57What is a dividend? How does it work? What is the thing that you tell people right out the gate? Yeah, I mean, what kind of sparked my interest in doing this series was seeing a lot more tweets and YouTube videos and articles touting dividend investing, that it's this really easy way to create income and it's a really easy way to make money in the markets. people go as far as saying that dividend investing can make you money while you sleep. And so you and I both know that that's not true, that there's a lot of misconceptions around dividends and dividend investing. And so I wanted to use this series to kind of clear up a lot of it and really help investors understand what dividends are.

2:33And so in short, I mean, dividends are not free money. Whatever you happen to read or stumble across on the internet, just remind yourself that dividends are not free money. A dividend is simply just a portion of a company's profits that they're sharing with shareholders. So a company that you invested in, they made some money. And in turn, they're deciding to give you a shareholder of that company, a partial owner, some of that money that they made. So money is actually leaving the company's pockets. It's being removed from their balance sheet and it's handed over to you. And so the key thing here to pay attention to is that the company, when they pay a dividend, has less cash as a result after paying that dividend.

3:11So dividends are really just a way for companies to share some of their profits and their excess profits that they've deemed that they don't need to continue operating to share some of that with their existing shareholders. And companies, when they have profits, they have three choices. They can reinvest in the company, they can pay a dividend or return cash to shareholder. And the other way they return cash to shareholders are stock buybacks. But the reason that I mentioned that is when we go back and look at returns of any given index or any given company, you can break it into three components.

3:44It's changes in earnings, it's cash return to shareholders, either via dividends or buybacks, and it's changes in valuation. I think sometimes when people are looking at the dividend, the tangible nature of it draws them to it. And so you'll find people who want to wait to sell a company until the dividend is paid or buy it before it's paid. But in fact, when a dividend is paid, the price of the company drops by that amount. Because as you just mentioned, now there's no more cash. Well, not no more cash. That cash is not on its balance sheet any longer. It's not some sort of cheat. It's not some sort of extra return, but it is an important piece of it.

4:23Yeah. You do see a lot of that floating around the internet that like, hey, you can just jump in and buy this company right before they pay their dividend, right? Collect the dividend, collect that free money, and then sell the stock. And as you kind of alluded to, it doesn't really work like that, there's this thing called the ex-dividend date, which determines who's eligible to receive the dividend. So even if you buy the stock before the ex-dividend date and you are eligible to receive the dividend, the price of that stock is going to drop by the amount or typically drop by the amount of the dividend on the day it's paid.

4:54So maybe it's worth sharing a simple example. And I shared this example in my series, but let's just say your favorite stock is trading at$50 per share. And this company declares a 50 cent dividend per share. In other words, for every share of the stock that you own before the ex-dividend date, the company is going to send you 50 cents. So Peter, if you own 100 shares of this company prior to the ex-dividend date, well,$50 as a dividend is headed your way. However, as you mentioned, on the day this dividend is paid, the share price of this stock is going to adjust accordingly. So in this example, the share price would adjust to$49.50.

5:30It's reduced by 50 cents, the amount of the dividend that's paid. So Peter, instead of you owning 100 shares at$50 per share, you'll now own 100 shares at$49.50 plus the 50 cents per share that you now have in cash. Now, as many listeners know, you can reinvest that 50 cents right back into your investment. And now your investment is unchanged. You have the same total value in your portfolio. But if you go and take that 50 cents, Peter and go spend it, well, then your portfolio has less money as a result of this dividend. So there's no magic here. It's not free money. Even if you try to game the system and hurry up and buy the stock before the dividend, well, the share price is going to adjust anyways.

6:06So you're not really in a better place as a result of the dividend. And I think what's confusing to people is when that stock price adjusts, there's more going on in the world than just the dividend paying out. There are people buying and selling. And so you won't necessarily see this in action when an individual company or a fund, for that matter, pays out the dividend. But that is what happens. And I think that's a big misconception in general. Perhaps we've already guided people to a bit more clarity where you don't need to buy or sell your individual stock or your fund ahead of or after the ex-dividend date.

6:40The other thing I think is we run into from time to time is people just getting so focused on the dividend yield when they're building a portfolio or choosing investments. You talk about in your series some better ways to think about portfolio construction. Do you mind going through that? Yeah. And I think it's worth highlighting too, that going back to this dividend reinvestment opportunity, when you get that dividend, you have the option to either spend it or reinvest it. If you just spend all the dividends that you receive, if that's your income source for retirement, well, over a long period of time, your portfolio is not going to keep up with the broad indexes.

7:15If you're just spending that cashflow, you're probably not going to be in the same place as if you were reinvesting it. So it's an important thing just to pay attention to when you have that option. Typically the default is that your investment will automatically reinvest those dividends, but some people get in the habit of spending them and just know that that's going to affect the long-term value of your portfolio. So just something to keep in mind there. But yeah, this is a common problem in investing. Investors getting too focused on the yield of an investment, the yield of a fund or the yield of a stock and choosing to own that fund or that stock just because of the yield that it's paying.

7:49And so this can lead to a lot of problems. It can lead to a riskier portfolio and it can lead to lower future expected returns. So instead of letting your needs and goals and risk target drive how you construct your portfolio, you're simply just allowing that the yield of an investment to dictate the risk return profile of your portfolio. So it's really backwards. You have to keep in mind that the highest yielding dividend stocks, they have the highest yield for a reason. They typically have high yields because a lot of them are junky overpriced companies and they're issuing these high dividends to try and attract more investors.

8:26So if you buy a basket of high yielding stocks or a high yielding mutual fund or ETF, it's naturally going to include some of these junky overpriced companies, and that's going to drag down the long-term returns of your portfolio. So in short, targeting yield and just buying something for the yield will likely over a long period of time increase the risk of your portfolio and reduce long-term returns. And I shared this quote from Meb Faber, which I think kind of just sums all this up before we talk about like, what's a better way to maybe go through the construction process. Meb Faber said that one of the basic tenets of investing is that if all else is equal, the less you pay for an investment, the better your future returns should be.

9:03And by that logic, the better the value at which we can purchase quality assets, the better position we should be for increased returns going forward. In other words, valuation matters. The price you pay for an asset has a significant influence on the return or lack thereof that you'll get. So we want to be careful about buying something for the yield because we might be buying things that are overpriced, right? Overvalued and buying things at a low price is really important to long-term success. So stop there and see if you have any thoughts before we talk about, well, if we're not going to buy something for the yield, if we're not going to let yield influence our portfolio, then what's a better way to go about the portfolio process?

9:43Well, I love what you shared there. And I assume that you're going to start talking about total return because ultimately as an investor, I don't really care where the dollar comes from. And that's one of the things that happens for a lot of people with a stock or a fund, and they're used to getting a certain dividend and they don't want to make a change to their portfolio because they spend the dividend or they like the dividend or the dividend is, in their mind, reliable. Whereas in reality, a dollar of price gain is the same as a dollar of income. Yes, it can be fleeting, but ultimately the total return is what matters.

10:19And I think there's a whole generation of investors that didn't necessarily come up in a world where total return was emphasized. I mean, heck, even bond investors weren't thinking about total return until Bill Gross sort of turned the whole concept of bond trading on its head a couple of decades ago. Like you said, I mean, your returns are going to come from a couple different sources from dividends, interest, and capital gains, capital appreciation. Like, I don't really care where it's coming from. I want to focus on what's the total return of my investment. That's great that a fund is yielding 9%.

10:50But if my total return is flat or negative after everything is factored in, like what did that 9 % yield really do for you? So yeah, we want to be careful about just looking at the yield. We want to look at the total return of your investment. And we can talk more about maybe total return versus yield and creating income and retirement and how that all plays together. But I do think it's important to maybe go back to the construction process. And again, we're not going to choose something for the yield, which believe it or not, I think is just more common than most people think. I think people get really hyper-focused on what's the yield of my portfolio?

11:22What's the yield of that stock or the yield of that fund? Most people just get this backwards. I think that your needs and goals should drive how you invest your money. And so if we think about it in that way, that we should let our needs and goals drive how we build our portfolio, how much risk we should take, then from there we can say, okay, we know what my needs and goals are. I know what my risk target is. Here's a simple three-step process that I put together for how somebody can go about building a portfolio that, by the way, it's going to pay dividends. Naturally, this portfolio will pay dividends, but the dividend yield did not influence how the portfolio was constructed.

11:55But of course, it's going to pay dividends because 75 % of all US large-gap companies pay a dividend. So if you have a properly built portfolio that's diversified, it's naturally going to pay some dividends. So to me, step one of this three-step process is just determine what asset classes belong in your portfolio. And just keeping it simple through your research or through what your advisor recommends, you might determine, hey, I want exposure to US stocks, international stocks, and real estate. Just really, really simple example. But step one is what asset classes belong in my portfolio based on what my financial plan says and my needs and goals and risk target.

12:27Then step two is the quote from Meb Faber is we want to make sure we're buying good asset classes or good companies at good prices. So now that we know what belongs in the portfolio, let's use our preferred valuation metric and let's determine what companies or segments inside of those broad asset classes have attractive valuations and higher future expected returns. So maybe you determine by using something like the Shiller PE ratio, that small cap value stocks are undervalued and large cap growth stocks are overvalued. So as a result, you might not remove large cap growth from your portfolio entirely, but you might tilt the portfolio a little bit more towards those small cap value stocks, maybe a little less from those large cap growth stocks.

13:06So that's a decision that you can make. And then finally, once you've identified some of these undervalued asset classes that you want to maybe overweight, then it's time to identify and implement your portfolio. What holdings are you actually going to purchase? And to determine what investment solutions you might use, you might use individual stocks or mutual funds or ETFs or a combination of all three. But regardless, your goal here is to ensure that you're getting the desired exposure to the asset classes that belong in your portfolio at the lowest cost. That's our goal there. And again, since three out of every four large cap US companies pay a regular dividend, my portfolio here, this three-step process, this portfolio will naturally pay some regular dividends, but the dividend yield was irrelevant to me during this whole construction process.

13:51You know, it's one of the things that when people talk to me about, not just stocks and funds, but options or hedged ETFs or overlays. Again, the income, people get so obsessed with the income. And there's a lot of people pushing income-oriented strategies. You actually performed some analysis on dividend-paying strategies versus the overall market versus non-paying dividends. Can you share some of those findings? Yeah. I mean, this goes back to focusing on the total return of something, that just because it has a high yield or a good yield doesn't necessarily mean that the total return of your investment, when all factors are considered is going to be healthy.

14:28So yeah, I went back to January 1st of 1995. And by the way, we don't have a ton of history here because there's not a lot of dividend focused funds that have been around for a long period of time. A lot of them have closed or merged. So there's not a lot of history here. So I went back to January 1st, 1995, where I found a total of 17 open-end dividend focused funds that are still in existence today. So these 17 are all still in existence today. And of those 17 funds, 15 of them, or roughly 88 % of them, underperformed the Vanguard S &P 500 fund through March 31st of this year. So from 1995 to March 31st of this year, almost 90 % of them underperformed just the simple Vanguard S &P 500 fund.

15:13So again, sure, on paper, they had higher dividends, but the total return was much less than just the broad market. Now, listeners might be saying, well, sure, but like two of those funds did outperform. So why don't we just find those two and just own those two? But hopefully we're all in agreement that unless you have a perfectly working crystal ball, it would have been impossible to pick those two funds 30 years ago and held those for those 30 years. And those two funds out of the 17 would have outperformed. Like just getting that right would be really, really challenging. Also, I think it's worth noting that just so people don't think I'm picking on these like old school, high cost, actively managed funds that of course, like these high fees dragged down the returns.

15:50One of the funds measured out of these 17 was Vanguard's very own dividend growth fund. The ticker is VDIGX. That was one of the 17 funds measured that underperformed during this time. So even some of the lower cost dividend focused funds have underperformed as well. It's not just these high cost active funds. So yeah, over long periods of time, these dividend focused funds, they typically underperform these broad markets for a handful of reasons, which I'm sure we'll get to. And I think what's maybe interesting, maybe not all that interesting, I don't know, but like 88 % of these funds underperformed, that's pretty much in line with the underperformance of just all actively managed funds in the universe.

16:29Roughly 80 to 90 % of actively managed funds underperform the passive broad-based indexes. So it's really not all that surprising that 88 % of these, let's call them kind of actively managed dividend funds underperformed. It's right in line with most other asset classes. That's a great point. And also the fact that you found 17 funds doesn't really even acknowledge the fact that probably a lot of those funds failed or got merged into funds. It's something that people don't really realize that thousands of funds come out every year and hundreds, if not thousands, are closed every year or merge into another one because they aren't performing as well.

17:05So you've already picked a sample that's benefiting from survivorship bias. And yet, to your point, it's still having the success rate that a traditional active manager would have. And I also think kind of going back to something I said earlier about the three components of return, it's changes in earnings, cash return to shareholders and changes in valuation. And that cash return to shareholders, perhaps dividend investing in the 30s, 40s, 50s, 60s, 70s mattered. But when the SEC made it possible to do stock buybacks in the 80s, that really changed the landscape of how corporate finance worked.

17:43And just to paint a picture for listeners on buybacks, I feel like generally speaking, they get misunderstood, but companies are buying back their stock on the open market. So they might announce, Apple might say, we're going to buy back$4 billion of stock. The one thing that when you're a company, if you announce a dividend, cutting the dividend is a big no-no. But buying back stock is a more flexible way to return cash to shareholders because you don't really get penalized for the same way when you cut a dividend. You cut a dividend when you're in bad financial health. The market realizes that the price often sells off.

18:18When they buy back stock, it's not like you have to buy back. They just go and buy on the open market. I think you quoted a stat about something from 1997 to present. The growth Both of buybacks far exceeded what dividends were paid. And in general, when you have the choice of paying a dividend and reinvesting in the company or buying back your stock or doing nothing, I guess you could just leave it there in cash. Buying back your stock sometimes is the best investment that you can make for a company. What sort of things do you feel like we ought to cover on buybacks for people to understand within that context?

18:52I think at the most basic level here, again, like companies make money and when they have excess profits that they don't believe can be used to help fuel future growth for this company, they have some options available to them. And buying back stock is one of them. Issuing dividends is another. Again, these aren't like magical things that automatically just make them a great company. These are just choices that companies have to make. And if you're going to invest in a company like Apple, you want to trust that their leadership is going to make the right decisions with excess profits, either hold onto a bunch of cash or distribute some of it through dividends or do some buybacks.

19:28There's a lot of, not a lot, but more and more negative press around stock buybacks. I would just remind yourself that stock buybacks aren't necessarily good or bad. There's a tool that the company has, an option that the company has to do something with some of that excess cash. I mean, we can get into the weeds all we want. If you want to go check out the episode that I did, I dig into some of the nerdy details there, but just in general, just, I don't know, companies have an option and this is one of those options. It's not necessarily a bad thing or a good thing. It's just one thing that they could do with those excess profits.

19:54Well, and again, for those of you listening, if you want to check out Taylor's episodes, go check out Stay Wealthy on your podcast app or visit thelongterminvestor.com. We'll have links to all the shows from the dividend series that Taylor has put out there into the world. And we are talking about how the dividend driven strategies tend to underperform, or at least historically have underperformed the S &P 500 index. Some of this is because they're poorly constructed. Some of it is because the fees are higher. But as it's related to buybacks, taxes is another thing. So when you get a dividend, you have to pay the dividend tax rate on that.

20:32When there is a buyback, that capital appreciation that is theoretically happening, you aren't taxed on that. You have a little bit more control over your tax bill. Now, it's not perfect, but ultimately, you have to trust that the way that the company is managing themselves is ultimately going to be optimal. Not everybody can be Amazon where they're just investing in new businesses and having them turn out. If you try to keep reinventing the wheel of your company, eventually you're just going to be wasting shareholder value. There was a long period of time where the pharmaceuticals, big dividend yield payers, were just acquiring and acquiring and acquiring.

21:06And now they're kind of gone in reverse the past decade where they're spinning off units because they were destroying shareholder value just to acquire things and make earnings grow. It didn't really have enough consideration to the full picture. And so when we think about dividend investing and how our goals should really be aligning with the way that we're building the portfolio, I think there is a right way and wrong way to be doing this, don't you think? Yeah, I do. And on that note about taxes, it's often forgotten about, especially when we're reading these articles or seeing these charts online, they don't typically factor in taxes to the analysis.

21:41And like you'd mentioned, every time you receive a dividend, well, you're also receiving a tax bill, assuming that this isn't a taxable brokerage account for, you know, let's push to the side pre-tax accounts or Roth IRAs. But in your taxable brokerage accounts, when you receive a dividend, you're also receiving a tax bill. Even if you reinvest that dividend back into the fund or the company, you have a tax bill that year. And those taxes can be a drag on your portfolio. So this highlights the importance of number one, just paying attention to the tax ramifications of your investments and ensuring that if you're going to have a taxable brokerage account, you might consider targeting maybe lower yielding investments in that account, something called asset location.

22:19We might put more tax efficient vehicles in that taxable brokerage account to help mitigate that tax bill. But there is research out there that says that depending on your tax bracket, the tax effect of dividends can reduce your annual returns by up to one and a half percent per year. So this is a real threat to your long-term returns by not focusing on taxes. And if you're just buying the highest yielding stocks or highest yielding funds, talk about total return, those taxes can further drag down that total return as well. 100%. And I think there's also research out that just shows the difference between companies with high investment in the firm and low investment within the firm.

22:56And we kind of go back to what is the best use of cash. And you will see from time to time, people demand that cash is returned to shareholders via dividend or buybacks. Usually when you have an activist investor, they say, stop wasting money on these projects. But there is pretty good research in there that the high investment versus low investment, there are differences in return that you can see in the data in peer reviewed research. And that's why it all comes back to developing not just your portfolio, but your financial plan using evidence, using facts, not feelings. Taylor, I know you've also done a lot of work talking about different withdrawal rate and income planning strategies.

23:35How does all of this fit into that within the world of dividend investing? Yeah, I mean, creating retirement income is often a big challenge for people. They can DIY their investments, their financial plan while they're accumulating money. Pretty easy, I'm making money, I'm saving money, I'll buy some low-cost index funds. And all of a sudden, they amass a nice, sizable nest egg of a few million dollars. Like, how do I turn this to$3 million into a retirement income stream. And again, the popular method or one that seems most attractive is I'll just target the yield, right? I'll just go buy some stocks or some mutual funds that have a three, four, 5%, 6 % yield, whatever yield I need.