I’m an active academic and long-time finance professor, so I stay on top of the latest academic research in the fields of finance, especially investments. On occasion, I will provide short, easy-to-read summaries of recent and relevant research, to help you give your clients the best and most cutting-edge investment advice.
When you invest in a stock, you can get your investment returns from two sources: dividend payouts and stock price appreciation. A portfolio that consists primarily of stocks that pay dividends is commonly called an “income portfolio.” A portfolio that consists primarily of stocks that are expected to experience price appreciation is commonly called a “growth portfolio.” Which is a better portfolio? Well, that depends on many factors, and in particular, it mostly depends on you and your situation. Some people may tell you that expected dividends are better than expected stock price appreciation because the former is more predictable and less volatile. But some other people may tell you that stock price appreciation is better than dividends because of the natural deferral of taxes. So, it’s a tough call.
However, a recent study published in the CFA’s Financial Analyst Journal makes a pretty compelling case for dividend-paying stocks. They studied over 50 years of data, from 1962 to 2014, of all publicly-traded U.S. firms. Their discoveries are pretty surprising.
First, the authors find that dividend-paying stocks can significantly reduce portfolio risk. Okay, that was expected. That’s not one of their surprising discoveries.
Second, the reduction in risk is achieved without a corresponding reduction in return. Now that’s surprising. You’d expect a risk-reduction would accompany a return-reduction. Reduced risk without reduced return is what most investors want.
But here are the two most surprising findings:
• First, even investors who like growth stocks should consider investing in dividend-paying stocks. The authors find that “For growth investors, the no-dividend portfolio offers by far the lowest return along with the highest risk, which is clearly suboptimal. No-dividend growth stocks are likely immature, fast growing companies that may entice growth investors to overpay. In options parlance, these stocks may be viewed as lottery tickets because of their potential for spectacular returns. By adding dividend exposure, growth investors can significantly reduce risk, while also increasing returns.”
• Second, even investors who like small cap stocks and mid cap stocks should consider investing in dividend-paying stocks. The authors find that “there is a clear advantage for small-cap and mid-cap investors in adding a dividend tilt. For these investors, the addition of a dividend exposure results in a significant increase in returns, less risk, and greater liquidity.”
Why are these latter two findings particularly surprising?
Well, some growth investors and small cap investors may shy away from dividends, as their focus is on stock price appreciation. They might think that firms that pay dividends don’t have the potential to generate huge stock price appreciation, and so they may think that their expected total returns could be higher without dividends. However, based on the recent study, it turns out that growth investors and small cap investors will likely earn higher total returns if they seek out growth firms and small cap firms that also paid dividends.
Overall takeaway? Maybe more of us should love dividends.
And, maybe it’s also time to look at, and invest in, an income portfolio, even if you are a growth or small cap investor.
Kenneth A. Kim is chief financial strategist at EQIS.