5 Reasons Why Dividend Investing Works

AUTHOR: Chris Vaughan

We haven't always been dividend investors, but after making the shift more than 12 years ago we’ve seen a noticeable difference in the type of conversations we have with our clients.

We believe dividend investing is the best way to secure a retirement income and beats capital investing for capital hands down. 5 of these reasons are exposed in this article.

We’ve spent a long time looking at the best way to use dividend paying stocks in a portfolio and have covered this space thoroughly looking for the best investment options for our clients.

We believe dividend investing is a fantastic way for individuals of all walks of life to reach financial independence, particularly those in or approaching retirement.

We’re fully aware that not everyone will be a fan of this approach and some people will be actively against this style of investing and we respect their opinions, but we hope you will give this approach due consideration after reading this article.

At the end of the day, you might disagree with us and we respect that. Our claim that dividend investing is better than capital gains investing applies to us and our investment philosophy, and works for our clients. It brings predictability to investment income which we believe is the preferred outcome for investors seeking to create financial independence.

Argument 1: The regularity of income

Whether you are focusing on dividends or on capital gains, we believe it is fair to say that we both share a common objective: to generate enough wealth in retirement to live comfortably. If this isn't your objective, or if your objective doesn't at all resemble this, then this article be of limited help.

But if this is your objective, it is safe to say that at some point you're going to want to start drawing some income from your investments, including pensions. If you own stocks that don't pay a dividend, you're going to have to sell a portion of your stocks each month. The price of shares goes up and down in effectively a random manner every day and the price of the shares will be different every time you come to make a sale to fund a withdrawal for income, this timing can have a serious impact on your portfolio.

A rule of thumb used to estimate whether you’re ready for retirement is if your portfolio is worth 25x more than your expected annual expenditure. This would mean you should be able to generate 4% returns per annum, in retirement and live off this forever.

However, if you’re invested in the stock market, you may be able to generate an average return of 4% per annum over 3 years but may not actually get exactly 4% in each of those years.

Let's look at an example.

Assume your annual expenses are £50,000, for simplicity, and you have £1,000,000 in stocks.

The month before you retire, the market suffers a real correction. Your portfolio loses 30% and stays there throughout the year. You then withdraw £50,000 at the end of the year.

You have £1,000,000 * -30% - £50,000 = £650,000 remaining at the end of the year.

The next year the stock market recovers somewhat, and your portfolio goes up 27%. You then withdraw another £50,000 at the end of the year.

You have £650,000 * 27% - £50,000 = £775,500 remaining at the end of the year.

The third year your portfolio goes up another 27% and again you withdraw £50,000.

You have £775,500 * 27% - £50,000 = £934,885 remaining at the end of the year.

Had you held onto the stocks you'd be up 13%, but because you had to make withdrawals, you are down 6.5%.

Now in this case, you'd probably be relatively relaxed about the £65,000 loss of the period and adjust your expectations and move on, but it is not a pleasant way to spend the first 3 years of your retirement. It assumes you don't panic and sell at the worst time, which is a surprisingly common trait among people.

If you think this sort of thing doesn't happen, just ask anyone who retired in March this year and how they felt about their upcoming retirement.

Dividend investing is great, because it takes away the stress of stock price movements. Granted, it shifts this stress towards the possibility of dividend cuts, and the dividend growth requirements, but we believe that this risk can be minimized by investing in proven companies, particularly investment trusts, with strong dividend policies and balance sheets that can sustain dividend payments through the worst the markets can throw at them.

Relying on a vehicle that produces income is much less stressful. For instance, look at the chart below which charts both BP’s (LSE: BP.L) dividend payments and stock price for the past 20 years.

The stock price is actually down over the period but it’s clear to see that the dividend payments have been on a steady trend upwards over the period. It’s very noticeable that the stock price is a lot more volatile than the dividend payment.

This predictability will contribute not only to your financial well-being, but it also contributes to your mental well-being.

Argument 2: You don't actually give up on capital gains

Many investors who don't like dividend investing point out that you are giving up on capital gains. While this might be true for some high yield stocks, this isn't the case across the board.

For instance, it is true that the Murray International Trust PLC has delivered marginal capital gains in the past decade and has not beaten the FTSE 100 based on price alone.

However, if we look at the F&C investment trust, despite being 12% off its peak, it is still beating the FTSE 100 over the past decade on price alone.

If you are of the opinion that you need capital gains too, you don't actually have to give up on them with dividend investing. You can have your cake and eat it too!

Argument 3: It keeps you away from bad stocks

This isn't to say all dividend stocks are good picks. In fact, this is far from the truth, there are plenty of awful dividend stocks. But by forcing yourself to evaluate the dividend policy of a company, this serves as a proxy for quality of company earnings, and when it comes down to it, you want to own high-quality stocks.

Following a clear-cut framework will give you a good sense of whether:

Management is shareholder friendly and provides timely relevant information.
The company generates enough cash to cover its dividend.
The company has been growing returns at a rate that is sufficient to continue paying the dividend.
The balance sheet is reasonable and not over-leveraged.

Without this, you might be too eager to get in on any of the latest craze your friend has been telling you about. Any framework that can help you avoid purchasing a stock whose chart ends up looking like this, is a good framework.

Granted, this may mean it’s unlikely that you would have invested in stocks like (say) JD Sports, but we have to remember our leading objective is provide enough wealth to live a comfortable retirement so what we’re really looking for is stability. Would you have really invested your entire portfolio into JD Sports in 2010?

We've found that a clear framework, founded on hard facts works a lot better for us. This very framework also means we identified and invested in investment trusts like the F&C investment trust which has performed fantastically, returning 10% per annum over the past decade…before dividends.

Argument 4: It teaches you when to buy and sell

When you look at dividend paying stocks for a long time you get a good impression of what they’re long term dividend yield is and where the fair price of the stock is for the value of the dividend they are paying. You also have the ability to see what profits they’re using to pay the dividend and the returns this is generated from.

We aren’t traders and are not buying and selling stocks as the price fluctuates to generate a couple of extra percent return as we believe the cost will outweigh the benefit but when we see the dividend yield rising and the dividend cover, the number of years they can continue to pay the existing dividend from reserves, falling then we know that it is likely a good time to get out.

Take, for example, the Temple Bar Investment Trust.

Their dividend cover at the end of 2019 was down to 1.03 years yet their dividend grew by 10% compared to 2018. Contrast this with JPMorgan Claverhouse Investment Trust whose dividend cover is only marginally higher at 1.07 years but their dividend growth over 2019 was much more reasonable at 5.45%.

These are only some of the metrics we look at when deciding when we should buy and sell a stock but we have been vindicated recently as we can see in the chart below comparing the returns of the two investments trusts mentioned above over the past 3 years.

Argument 5: It suppresses many of your biases

In the past 40 years, a lot of research in investing has focused on behavioural economics which cause individuals to make decisions which result in them underperforming the broad market. The mainstream response has been to follow the concept of "if you can't beat them, join them", and invest in broad market tracking funds.

Our approach and the approach of dividend investors has been to change the focus from market value to income. We set an income goal for retirement and calculate how much is actually achievable and benchmark our success by asking our clients the question: Are you still on track to live the retirement you want?

If the answer is yes, the fact that you beat the market becomes irrelevant. Day to day movements in prices can be seen as opportunities if there is spare capital to invest. When the success of your retirement doesn't depend on the value of a share then you can take a more rational, long-term view to the value of your investments and in the process make better decisions.

Conclusion

Will dividend investing result in better outcomes for you? The answer depends on how you define outcomes. Someone could read this and compile 5 reasons why capital investing is better than dividend investing. Will you be guaranteed to get better returns by using dividend investing over capital investing? No, is the short answer. Will you feel more secure in your retirement when seeing a steady stream of income coming into your bank that outpaces inflation? We believe the answer to that is an emphatic yes.

Keeping focus on a sustainable, robust, simple investment process which doesn’t deviate from the original objective is what will keep you sane in retirement and avoid the pitfalls common among all investors.

Think of this as well – people will always grow old and always retire, so pension income will always be needed, meaning the large institutions will always be investing in dividend producing stocks and funds.

This investment style is boringly simple but consistent. As Mr Buffett says, it’s about not trying to jump a seven foot fence, but finding one foot fences to step over. The key to removing anxiety from your investing.