Dividend Stocks vs. Total Return Investing
In Part 1 of “What’s Wrong With Depending on Dividend Stocks?” we described why dividend investing—or, stocking up on stocks with a reputation for consistently paying out attractive dividends—may not be an ideal strategy for generating a dependable income stream out of your investment portfolio.
Today, we’ll look at why we prefer a total return investment strategy instead of seeking more concentrated dividend stock positions, even for retirees who are drawing income out of their portfolios.
Relative Worth
Admittedly, there are more dubious ventures than concentrating on dividend stocks. Take, for example, piling your life’s savings into speculative schemes such as cryptocurrency, SPACs, or Jim Cramer’s latest “Mad Money” picks. (Here’s John Oliver’s clip on that, for a laugh.)
But rather than settling on dividend investing, here are two questions for homing in on a better way to build and spend your lifetime wealth:
- Investing: As you invest and accumulate wealth over time, how can you pursue the highest total return over time, given the level of market risk you can tolerate?
- Divesting: As you take income out of your portfolio, how can you best maintain its risk-managed structure, while generating the most tax-efficient withdrawals over time?
Where dividend investing falls short on these pivotal counts, total return investing is better structured for directly addressing them, head on.
Types of Dividend-Paying Stocks
Not all dividend-paying stocks are cut from the same cloth. You’ll find two primary flavors in the financial pantry:
High-Yield Dividend Stocks: These companies dole out sizable dividend payments, usually as a percentage of their share price. Think utilities, real estate investment trusts (REITs), or certain energy firms. They’re often steady eddies but can signal trouble if the dividend looks too good to be true—sometimes a result of recent stock price drops or shaky fundamentals beneath the surface.
Dividend Growth Stocks: Here, you’ll find companies known for regularly increasing their dividend payouts year after year, like some “Dividend Aristocrats” you’ll see on well-worn lists from S&P or the likes of Procter & Gamble and Johnson & Johnson. These tend to be established businesses with a track record of balancing both shareholder rewards and responsible growth.
A word of caution: chasing the highest dividend without considering the company’s long-term prospects or financial health can be as risky as betting it all on a coin toss. It’s essential to weigh not just how much is being paid but whether it’s likely—realistically—to keep rolling in for years to come. Look for signs of sustainable earnings and manageable debt, and always align your picks with both your income needs and your tolerance for risk.
Dividend Stocks in Stormy Markets
So, what role do dividend-paying stocks play when markets get choppy? Picture the markets as a roller coaster—twists, unexpected dips, and the occasional upside-down loop. During those wild rides, dividend stocks can act a bit like the safety bar holding you steady. Even if share prices are in free fall, these stocks often continue paying out dividends, offering you a steady drip of income regardless of which way the market winds are blowing. This income stream can help soften the impact of falling share prices, serving as a cushion for your portfolio during tough times.
Additionally, companies with a solid track record of paying dividends tend to be more established and financially resilient. Historically, these stalwarts have weathered downturns with a bit more poise than their non-dividend-paying cousins. As a result, adding dividend stocks to your mix may help reduce your portfolio’s volatility, keeping things a tad less nerve-wracking when the headlines start looking grim.
How Does Total Return Investing Work?
Bottom line, there are essentially three ways any given investment can reward investors:
- Interest/Dividends: A security can pay out more or less interest or dividends.
- Capital Appreciation: A security can offer higher or lower capital gains or losses (based on how much you pay per share versus how much your shares are worth when you sell them).
- Cost Control: As you buy and sell your holdings, you can incur more or fewer taxes and other costs that eat into your returns.
Instead of seeking to isolate and maximize dividends as a single solution, total-return investing seeks to make best use of all three of these potential money-making tools as they apply to you, your investment opportunities, and your personal financial goals.
Total return investing offers more flexibility for pursuing overall expected returns within your risk parameters—regardless of where those expected returns come from.
Also, dividend investing limits you to investing in no more than about 40% of all publicly traded stocks. With total return investing, we can consider the entire universe of available stocks.
Expanding Your Toolkit: Options Beyond Individual Dividend Stocks
If you’re looking to tap into dividends without hand-picking individual stocks, the menu is surprisingly robust. You don’t have to limit yourself to building your own shortlist of high-yielding blue chips. Instead, you can harness a variety of professionally managed vehicles that do the legwork for you.
For starters, consider exchange-traded funds (ETFs) and mutual funds that specialize in dividend strategies. These might track indexes of companies known for consistently paying—or growing—their dividends. There are funds that focus on high dividend yield, those that target dividend growth, and others that blend the two. If global exposure is your thing, you’ll also find international and global dividend funds that add further diversification, tapping into companies beyond U.S. Borders (where, interestingly, some markets offer a richer dividend yield buffet than domestic indexes).
The real advantage? With these pooled investment vehicles, you can efficiently diversify across dozens or even hundreds of dividend payers in a single purchase, saving you time, paperwork, and—just as crucially—the awkward task of explaining to your family why you’re all-in on a single company’s payout policy.
Of course, what’s best for you depends on your goals, risk appetite, need for liquidity, and time horizon. The specific blend of funds (domestic vs. International, yield vs. Growth, etc.) should fit your overall financial plan, not just your appetite for quarterly checks.
As we’ll see next, evidence suggests this is an important differentiator.
Evidence-Based Underpinnings
Total return investing is grounded in decades of academic evidence identifying the stock market’s true sources of expected returns. These include investing in stocks versus bonds to begin with, as well as incorporating return factors such as company size, book value, and profitability.
The research is clear: Whether or not a company pays out dividends is NOT among these identified return factors. We’ve known this since at least the 1960s, when Nobel laureates Merton Miller and Franco Modigliani published their landmark study, “Dividend Policy, Growth, and the Valuation of Shares.” They found, if you omit external factors such as trading costs and taxes, investors should be indifferent to whether companies distribute shareholders’ profits as capital gains or dividends.
In a recent VettaFi Advisor Perspectives piece, Larry Swedroe of Buckingham Wealth Partners revisited this conclusion with his own analysis of four popular dividend-appreciation ETFs. He looked at whether they outperformed their counterparts after accounting for the types of investment factors that drive expected returns. Swedroe concludes:
“Be skeptical of strategies that conflict with economic theory. Even without considering the negative tax implications of a dividend-paying stock … investors are better served by directly targeting factor exposures in their portfolio rather than using a dividend screen, which reduces the investable universe significantly.”
The Benefits of Total Return Investing
As total return investors, we can still draw from and make best use of available dividends and interest. Because, on a purely rational level, a dollar is a dollar and a return is a return, no matter how it’s paid out.
But whenever it may make more sense to do so, we can also sell positions to generate income. We can also prioritize managing an investment portfolio and income withdrawals as cost- and tax-efficiently as possible, without having to maintain a dividend-stock exposure.
By building from this position of strength, you can pursue the outcomes that make the most sense for you. Would you like to have more income to spend in the end? Experience less market volatility along the way? Create a balance between growth and stability? Total return investing gives you far more ways to mix and match the pieces of your portfolio accordingly. In fact, most total return portfolios still include dividend stocks; they’re just no longer a central pursuit.
Choosing Dividend Stocks to Match Your Goals
Just as building an effective total return portfolio depends on your unique circumstances, selecting dividend stocks should also start with your personal objectives in mind.
If your primary aim is to generate a steady income, you might naturally gravitate toward companies with a solid history of paying reliable, above-average dividends. Blue-chip firms—think names like Johnson & Johnson or Procter & Gamble—are well-known for longstanding dividend payouts. These may offer greater predictability for covering regular expenses, though it’s wise to consider whether the yield is sustainable or a red flag of underlying trouble.
On the other hand, if you’re less concerned with immediate cash flow and more interested in future growth, you could favor companies that consistently raise their dividends over time. This approach can serve to outpace inflation and build a rising stream of income down the line as the company’s profits and cash flows expand. You’ll often find firms like Microsoft or PepsiCo have demonstrated this kind of dividend growth.
Of course, whether you seek income now or later, keep diversification top of mind. Relying too heavily on any single sector or group of dividend-payers can magnify portfolio risks. Instead, look for a balanced mix—across industries and geographies—anchored by your own needs, not just the highest current yield or the shiniest upward trend.
The Role of International Dividend Stocks in Diversification
Expanding your portfolio to include international dividend-paying stocks can further enhance diversification. Different countries and regions are often subject to unique economic cycles, market dynamics, and regulatory environments. By incorporating global dividend stocks—such as those found in indexes like the MSCI EAFE or FTSE All-World ex-US—you can tap into varied sources of income and reduce the risk associated with being concentrated solely in U.S. Markets.
Additionally, international dividends sometimes offer higher yields compared to their U.S. Counterparts, presenting opportunities for increased income. This broader reach means your portfolio isn’t just tied to the fortunes of a single country, strengthening your resilience against localized downturns and potentially smoothing out your investment journey.
Total Return Approach | Dividend Investing | |
Portfolio Management | We seek to optimize your exposure to the capital available from global stock and bond markets by building a personalized portfolio, invested across risk-managed, global sources of expected returns. Income is then withdrawn out of your total returns, with an emphasis on maximizing efficiency and minimizing costs. | Dividend investors seek to draw their income from a concentrated position in stocks (or stock funds) with a past history for distributing dividends. |
Concentration Risk | To curtail unnecessary risks related to overly concentrated stock positions, we invest in funds that offer broad diversification within and across the types of investments you’re holding. | Loading up on stocks that happen to have been paying dividends erodes rather than augments your ability to diversify away excess concentration risk. |
Tax Management | We emphasize tax efficiency as you invest and spend your wealth. For example, we’ll locate your diverse investments across taxable and tax-sheltered accounts as appropriate, and withdraw income wherever and however is expected to be most tax-efficient over your lifetime. | Dividend investing limits rather than enhances your ability to control when and how your income stream will be taxed over your lifetime, as well as where your most tax-efficient income holdings can be managed. |
By concentrating on dividend stocks, investors are inadvertently investing in a byproduct of the market’s actual sources for expected returns. Why not invest directly in these sources themselves? By focusing on your portfolio’s total return as the horse that drives your proverbial cart, we believe we can best manage expected returns, and best position your portfolio to generate efficient cash flow when the time comes.
If you’d like to know more, please be in touch.