MYTH: The higher the dividend yield, the more attractive the stock.
We see too many investors fixated on the dividend yield, which is the dividend divided by the stock price. For example, an investor picks up their statement and sees that he or she owns a stock with a 5 percent dividend yield and a value of $10/share ($0.50 dividend divided by $10 = a dividend yield of 5 percent). The investor feels good about getting a nice return, especially when the bank is paying less than 1 percent. The investor picks up next month’s statement and sees that the same stock now shows as having a 10 percent dividend yield. What can be better than that? The investor should probably scroll over to the stock price:
Dividend of $0.50/share
Dividend yield of 10 percent
Stock price = $5/share ($5 price X 10 percent dividend yield = a dividend of $0.50/share)
So, while the investor is feeling better because his or her dividend yield is going up, in reality he or she lost $5/share and should be feeling worse.
An Alternative Approach To The Dividend-Only Philosophy
Looking back a few decades, it was easy to find bonds paying double digits and stocks yielding attractive dividends, which could help supplement someone’s income. However, those days are long past with secure 10-year U.S. government bonds paying 1.8 percent as of this writing and the current S&P 500 dividend yield standing at 2.08 percent. Clients who go reaching for yield often end up buying risky, long-term bonds and stocks of companies they don’t want to own simply to get the dividend. All too often they are pushed into high-yield bonds (aka junk bonds) that are susceptible to large losses if interest rates rise (as the Fed seems inclined to pursue such a policy) or the economy suffers. Time after time, we see clients who own an equity portfolio primarily consisting of real estate and oil pipeline stocks, which do pay high dividends, but have seen large portfolio losses in times of volatility.
We believe that clients need cash flow, not income, so we divide a portfolio into two buckets. Each client who needs cash flow has an amount equal to their twelve-month cash needs set aside in an interest-bearing savings account and the balance of their investments can be used to purchase a diversified, prudent portfolio consisting of multiple asset classes, regardless of whether each individual investment pays out income. It allows us to own high-quality bonds to preserve principal, dividend and non-dividend paying stocks both in the U.S. and abroad, as well as other asset classes like real estate, commodities and alternative funds. Due to the fact that the client has a large cash balance, we don’t need to arbitrarily avoid solid investment ideas simply because they don’t provide annual income. The goal is to achieve maximum total return made up of interest, dividends and capital appreciation.