Common Myths About Dividend Paying Stocks
Dividend-paying stocks are often touted as an excellent investment choice for income-seeking investors. Proponents of these stocks argue that their steady income stream and perceived lower risk make them a superior choice, especially in uncertain economic times. However, a closer examination reveals that the allure of dividend-paying stocks is premised on some fundamental myths.
The Appeal of Dividend-Paying Stocks
Dividend-paying stocks have long been an attractive option for investors. The idea is simple: Dividend investing can be a way to obtain a steady stream of income by paying shareholders an annual dividend payment, calculated as a percent of the current price.
If you elect to reinvest your dividends, you can increase your returns.
Myths Surrounding Dividend-Paying Stocks
While dividend-paying stocks may seem like a safe and reliable investment option, That’s not always true.
Here are some fundamental myths about dividend-paying stocks.
Myth #1: Dividend-Paying Stocks Provide a Stable Income Stream
One of the most pervasive myths about dividend-paying stocks is that they provide a stable and predictable income stream. While it is true that companies that consistently pay dividends are typically more stable than those that do not, this does not mean that dividend income is guaranteed.
Companies can and do cut or eliminate their dividends in response to financial challenges or changes in their business strategies. This can significantly reduce an investor's expected income and potentially result in losses if the stock price declines due to the dividend cut.
You can find a list of companies with a market cap above $10 billion that have cut their dividends since the beginning of the pandemic here. The list includes well-known companies like Anheuser-Busch, The Blackstone Group, Haliburton, MGM, and Schlumberger.
Myth #2: Dividend-Paying Stocks Are Lower Risk
Dividend-paying stocks are often perceived as lower risk compared to non-dividend-paying stocks. The perception of lower risk is based on the belief that companies paying dividends are typically more established, have a history of profitability, and generate consistent cash flows. As a result, they are often seen as more stable and less susceptible to extreme price fluctuations.
However, paying a dividend may cause the stock price to decrease, resulting in a potential loss for investors.
Just because a company pays a dividend, and has done so for many years, does not protect investors from significant losses in the underlying stock.
General Motors, J.C. Penny, Kodak, and Radio Shack are among the well-known dividend-paying stocks that have collapsed. You can find a more comprehensive list here.
Myth #3: Dividend-Paying Stocks Deliver Superior Long-Term Returns
There is evidence that dividend policy is irrelevant to returns.
One study sought to determine if stocks with a pattern of increasing dividends yielded abnormal returns. The authors found evidence of abnormal returns around the first and second increases, but this impact largely disappeared for subsequent increases.
Myth #4: Dividend-Paying stocks are diversified
If you screen for only stocks that pay dividends, you eliminate “60% of the eligible stocks and about 20% of total market capitalization.”
A portfolio consisting of only dividend-paying stocks is less diversified and less efficient than one with a broader universe of stocks.
Myth #5: The source of returns is significant
Should it make a difference if the source of your returns is appreciation in the price of a stock or the receipt of a dividend?
Not according to a 1961 seminal paper entitled “Dividend Policy, Growth, and the Value of Shares” by Merton Miller and Franco Modigliani. The authors established that dividend policy should be irrelevant to stock returns, meaning $1 from the stock's appreciation is the same as a $1 dividend (before trading costs and taxes).
The final word on dividends
The myth of dividend-paying stocks as a universally superior investment option has persisted for too long. While these stocks can provide a source of income and may be appropriate for some investors, they are only suitable for some.
Instead of focusing solely on dividends, investors would be well-advised to create a diversified portfolio that considers factors like market, size, value, profitability, investment, and momentum. These factors have been shown to drive returns. Whether a stock pays a dividend has little relationship to returns.
A well-diversified investment strategy incorporating dividend-paying and non-dividend-paying stocks is likely the most effective approach for achieving long-term financial goals. By adopting this more nuanced perspective, investors can separate myth from reality and make better-informed decisions aligning with their needs and objectives.
At Daner Wealth, our investment recommendations are based on sound academic principles.
The myth of dividend-paying stocks as a universally superior investment option has persisted for too long. While these stocks can provide a source of income and may be appropriate for some investors, they are only suitable for some. Instead of focusing solely on dividends, investors would be well-advised to create a diversified portfolio that considers factors like market, size, value, profitability, investment, and momentum.
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