digest
Short Summary
Main recommendation: Investors should avoid income investing, which means building a portfolio of dividend-paying stocks, preferred stocks, and bonds to fund spending, and instead use a Total Return approach by investing in a globally diversified portfolio of total market index funds. Ben Felix argues that dividends do not make stocks better investments, because a dividend reduces the share price by the same amount, so the investor is no better or worse off.
Key Points
- Dividend-paying stocks are not inherently better investments; the five factors that explain most stock returns do not include dividends, while company size does.
- The "dividend irrelevance theory," from a 1961 paper by Merton Miller and Franco Modigliani, holds that a dividend lowers the company's value by the same amount paid out, so total returns are unchanged.
- Income-focused investing is tax inefficient for taxable investors, because dividends are taxed whether or not the investor needs the cash, while growth-based returns let investors defer tax by not selling.
- Dividend-focused portfolios sharply reduce diversification, since about 60% of US stocks and 40% of international stocks pay no dividend at all.
- Dividend investing often excludes small-cap stocks, which rarely pay dividends and have historically had higher long-term returns than large-cap stocks.
Details Worth Noting
- Concrete instructions: Build a globally diversified portfolio of total market index funds rather than selecting dividend-paying securities, and for taxable accounts, prefer returns from growth that you can realize by selling shares only when you need to spend.
- Statman and Shefrin's 1984 paper suggested investors favor dividends because of poor self-control, since a cash-flow approach sets a spending limit, and because of loss aversion, since people will sell shares reluctantly after a decline but happily spend a dividend regardless of share value.
- Dividends still matter: one dollar invested in the S&P/TSX Composite Price Only Index in 1969 was worth 14.37 dollars today, versus 64.59 dollars in the S&P/TSX Composite Index including dividends, and Canadian dividends receive favorable tax treatment.
- Felix argues the Total Return approach captures all market returns while keeping tax efficiency and diversification, rather than limiting holdings to dividend payers.
Bottom Line
A dividend is not free money: it is a transfer from the share price to the shareholder, so chasing income over total return narrows diversification and can increase taxes without improving results.
