Last week, a reader forwarded an article from U.S. News & World Report titled “7 Myths About Dividend-Paying Stocks,” written by Daniel Solin.
It’s received a lot of notice among the dividend crowd. But in the words of Vice President Biden, “With all due respect, that’s a bunch of malarkey.”
Let’s take a look at what Solin says are the seven myths about dividend stocks.
[ad#Google Adsense 336×280-IA]Myth: Dividends Hold Up in Bad Markets
Solin said that in 2009, 57% of dividend-paying companies reduced or eliminated their dividends.
To be clear… Solin is saying the idea that dividends hold up in a bad market is a myth.
Assuming that’s true (I haven’t seen the numbers myself), it’s important to remember two things.
The Great Recession wasn’t a bad market.
It was a historically bad market, second only to the Great Depression. The economy was on the verge of collapse. This was not just a recession or even deep recession. It was very close to financial Armageddon.
The other important thing to note is while many companies may have cut their dividends, the vast majority of what I call Perpetual Dividend Raisers – companies that raise their dividend every year – did not. In fact, they increased their dividends.
As of December 2013, there were 476 companies that had raised their dividend every year for at least five years including the years of 2008 and 2009.
So the lesson here is not just to buy any stock because it pays a dividend, but to own stocks that raise the dividend every year.
Myth: Dividend-Paying Stocks Outperform the Market
Solin states that “from 1991 to 2012, the average annual returns of dividend-paying stocks and the global stock market were both 9.1%. During the same period, stocks not paying dividends had an average annual return of 11.1%, although the higher returns came with greater volatility.”
That’s true. Dividend stocks did not outperform the broad market over the past 20 years. However, again, we’re talking about all dividend stocks. The ones you should be focusing on are Perpetual Dividend Raisers.
In similar terms, a Dividend Aristocrat is a member of the S&P 500 that has raised its dividend every year for at least 25 years. (Note: A Perpetual Dividend Raiser is any company that has raised its dividend every year for five years or more.)
According to MarketWatch, the Dividend Aristocrat Index posted a total return of 169% versus 143% for the S&P 500 during the current five-year bull market.
Additionally, in 2008, when the market tanked 37%, Dividend Aristocrats fell 22%.
Over the last 10 years, the Aristocrats gained 165% versus the S&P 500′s 102%.
Myth: Dividend Stocks Provide Adequate Diversification
I don’t think that’s a myth about dividend stocks. I’ve never heard that before. You can have a diverse portfolio of dividend stocks. But without proper asset allocation, no group of stocks automatically provides diversification.
Myth: Dividends Are a Reliable Source of Income
The author’s main issue here is that taxes on dividends could go up.
The tax argument is ridiculous. Future taxes are a wild card and anything can happen. Furthermore, you can protect your dividends from taxes by holding them in a tax-deferred account, like an IRA or 401(k).
Myth: Dividends Are Tax-Efficient
Solin says dividends are less tax-efficient than capital gains because you are not taxed on capital gains until you sell the stock.
It’s true that you only pay taxes on capital gains when you sell, because that’s when you get the money.
Typically, you pay taxes when you receive money. If a stock runs up from $10 to $100 over 10 years, it’s not like you’re enjoying the gains from that investment during those 10 years.
Just like any income, unless it’s protected in a tax-deferred account, you pay taxes on dividends. And currently, the taxes on dividends are below ordinary income tax rates.
If you hold your dividend stocks in a tax-deferred account and reinvest the dividends, you accelerate the magic of compounding by deferring the taxes until a later date.
Myth: Buying Dividends Stocks Is a Prudent Exposure to Value Stocks
I don’t think this is a myth either. Because dividend payers are typically more mature companies, they’re usually not high-flying momentum stocks. But anyone who blindly believes that because a company pays a dividend, it must be a value stock has not attempted to learn anything about the company.
Myth: Dividend Stocks Are a Substitute for Bonds
Solin’s piece states that some investors think they can improve their yields without taking on additional risk by purchasing dividend stocks and selling bonds, particularly high-quality short-term bonds.
This is also ludicrous. Anyone who thinks dividend stocks carry less risk than high quality short-term bonds doesn’t know enough to be investing their own money.
Bonds, even higher-yielding bonds, belong in a well-diversified portfolio – if the investor plans to hold the bond to maturity.
However, I advocate investing in Perpetual Dividend Raisers for most investors’ long-term money needs. With a bond, the annual income will remain the same over the long term. So the investor will lose buying power.
With a Perpetual Dividend Raiser, the income will rise every year and in most cases increase your buying power (the boost in dividend yield should be higher than the inflation rate).
The nice thing about a bond is that you’re nearly guaranteed to get your money back, even in high-yield bonds. Stocks, as you know, can fluctuate.
But that’s why I recommend taking any money that you need in the next three years out of the stock market. That way you don’t risk being in a bear market at the time you need your cash. For most of the rest of your capital, Perpetual Dividend Raisers will boost your income year after year.
Since dividend stocks have been popular for a while, headline writers have been trying to gain readers by scaring dividend investors into thinking their favorite strategy will no longer be effective.
Don’t fall for it. The strategy of investing for the long term in Perpetual Dividend Raisers has worked for decades and should continue to do so.
— Marc Lichtenfeld
Source: Wealthy Retirement