Dividends are like waterholes on African savannahs, and they’re increasingly popular thanks to drought-like interest rates. Ten-year U.S. Treasury Bills pay about 0.66 percent per year. Most CDs pay less than 1 percent. In contrast, high-dividend paying stocks or ETFs might dish out 4 percent or more.
That’s why plenty of retirees drink from dividend water holes. Young investors, also, are willing to lap them up. After all, instead of spending dividends (as a retiree would), younger investors can reinvest them, in hopes of higher total returns.
Consider a retiree who chooses the iShares Core High Dividend ETF (HDV). It includes 74 high-dividend paying stocks, sporting a 12-month dividend yield of about 4.12 percent. On the surface, that sounds great. A retiree might say, “I can live off these dividends without selling shares.” However, another retiree might say, “Why should I own high-dividend paying stocks? I can invest in a broad market index (with a lower dividend yield) and just sell some of the shares when I need the income.” You could call this, “a home-made dividend.”
At first glance, the high-dividend payout makes more sense. But Larry E. Swedroe and Andrew L Berkin say that isn’t true. In their latest book, The Incredible Shrinking Alpha (2nd edition), they explain that dividend payments are no free lunch.
For example, when a company pays a dividend, it reduces the value of that company in direct proportion to the cash it pays. In other words, if a business paid shareholders a total of $500 million in dividends, the company’s book value lowers by exactly $500 million. That $500 million “corporate loss” cannot be reinvested back into the company. As a result, the business can’t use that money for future growth. Long-term, this hampers share price growth.
This is why Berkshire Hathaway doesn’t pay a dividend. Retirees who bank on Berkshire sell portions of their shares when they require income.
The company’s chairman, Warren Buffett, has successfully retained and reinvested all net corporate earnings. As a result, Berkshire’s share price has experienced higher long-term growth than any high-dividend paying stock.
In Berkshire’s case, paying a dividend doesn’t make sense because Buffett is good at using the company’s capital to generate high, internal profits. But with most other companies, whether they pay a dividend or retain their earnings for future growth matters little to investors. Swedroe and Berkin say the total return for investors, on aggregate, works out about the same.
And that’s the important part to remember: total return. A high-dividend paying ETF provides lower, long-term share-price growth. That’s because the companies within the index hamper their own growth by paying high dividends. In contrast, lower-dividend paying ETFs have higher growth potential. The companies within the index retain a higher percentage of their earnings. This allows them to grow their businesses further, which boosts their share prices.
So what’s the best option for total return? Swedroe and Berkin say it’s a wash. PWL Capital’s Benjamin Felix says the same thing in this impressive YouTube video. But that’s only the case in tax-deferred accounts. In taxable accounts, Swedroe and Berkin say high-dividends hurt investors. They write:
“What is particularly puzzling about the preference for dividends is that taxable investors should favor the self-dividend (by selling shares) if cash flow is required. Unlike with dividends, where taxes are paid on the distribution amount, when shares are sold, taxes are due only on the portion of the sale representing a gain. And if there are losses on the sale, the investors gains the benefit of a tax deduction.”
Swedroe and Berkin also say investors should drink from different water holes. In other words, investors who focus on high-dividend paying stocks or ETFs won’t be as diversified. For example, a broad U.S. stock market index holds more than 3000 stocks. But a high-dividend paying ETF might hold fewer than 100.
The authors, however, do see a flipside that’s worth considering. Plenty of investors speculate. They freak out when stocks drop. In some cases, seeing strong dividends entering an account might prevent these investors from selling everything at a low. If high-dividend payments would help you keep calm, then the lower diversification and lower after-tax returns of high-dividend paying ETFs might not matter much. After all, investing is more about mastering emotions than picking the perfect products.
Andrew Hallam is a Digital Nomad. He’s the author of the bestseller Millionaire Teacher and Millionaire Expat: How To Build Wealth Living Overseas