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The Best Interest » No Free Lunch: The Truth About Dividend Investing

No Free Lunch: The Truth About Dividend Investing

Little kids can be brilliant. And stupid. Sometimes in the same sentence.

My friend Trey tells a story from when he was 5 years old. He had a eureka moment (or so he thought). It started when he saw a video of a dirt bike going up a near-vertical wall. Trey was inspired.

Climbing the Wall - Enduro Technique Training - YouTube

Trey imagined lining up two dirt bikes tire-to-tire and pointing them upwards and hitting the gas at the same time. Vroooooom. Bike A would use Bike B as a “wall” to accelerate up. And Bike B would simultaneously climb up Bike A. In tandem, Trey believed two dirt bikes could fly. Watch out, US Airways, there’s a new competitor in town.

Reality, of course, doesn’t support Trey’s dream. There’s no “free lunch” in physics. The bikes would spin themselves into the ground, assuming they didn’t just flop onto their sides first.

But Trey’s wonderful imagination has infiltrated part of the investing world.

Dividend investors have their own “flying dirt bikes.” Your investing accounts will be zooming skywards in no time.

But just as physics shot down Trey’s dirt bikes, basic arithmetic shows the “magic” of dividend investing is just a castle in the sky.

What Is Dividend Investing?

Let’s define today’s punching bag.

The fundamental value proposition in general stock investing is two-fold:

  1. First, we hope a company’s capital value increases. We want them to invent valuable intellectual property, buy land, build factories, earn more cash, etc. All this growth comes from them investing money, including their own earnings, wisely. We can then sell our stocks for capital gains.
  2. Second, we hope a company’s earnings increase. Some of those earnings will flow to us as part-owners of the company. Those payments to shareholders are called dividends. The dividends we receive today, tomorrow, and every day in the future add up to increase the net present value of the company.

Notice: both capital value and dividends are a function of earnings. All investors’ total returns are a function of earnings. This is a vital point that we’ll return to.

Dividend investing is a branch of stock investing where investors use a company’s dividend payments as a primary factor in buying the stock. By collecting a portfolio of dividend-paying stocks, these investors are ensuring they’ll receive strong dividend cash flow on a regular basis.

Aren’t All Stocks Dividend Stocks?

Since stocks only have two types of value (capital growth and dividend yield), you might ask, “Aren’t all stocks paying a dividend?

Not quite.

Famously, Amazon has never paid a dividend. Amazon is still growing, and growing companies rarely pay dividends. Instead, they reinvest their earnings into the company in pursuit of more growth. For this reason, Amazon would not be attractive to a dividend investor.

Berkshire Hathaway has never paid a dividend either. Warren Buffett strongly believes “for every dollar retained [by Berkshire], at least one dollar of market value should be created for owners.” When Buffett re-invests $1 into the company, they’ll find smart ways of turning it into more than $1 in capital gains.

But most companies will (at some point) pay a dividend. They’ll have limited internal opportunities for growth. The best option for shareholders, therefore, is to raise a dividend.

And they’ll become a potential target for dividend investors.

The Bad Logic of Dividend Investing

My thesis today is simple.

Dividend investing isn’t bad. It’s overhyped. And it’s overhyped because too many Internet gurus are sharing, quite simply, bad information. (Remember, “the term guru is popular because the word ‘charlatan’ is hard to spell.”)

Dividend investing promoters are full of bad logic. Remember the two dirt bikes flying in the sky? It’s like that.

So let me explain some of the purported benefits of dividend investing, and then explain why those so-called benefits are misplaced.

Bad Logic #1: “I Get Paid and I Still Own the Stock!”

Dividend investors laud the “free lunch” they get from dividend payments. After all, they’re getting a quarterly cash payment and they still own the underlying stock! What a deal!

First, as we’ve covered, this is how most stocks work. It’s not special. It’s like saying, “My boss gave me a paycheck and I’m still employed!” Okaaaaayyy. That’s how jobs work. Welcome to Earth.

Dividend investors believe their dividend payments are “something for nothing” since they still own their full share of stock. This is a false premise.

Let’s say I’m the CEO of $BEST. The stock is trading at $100 per share. And I choose to pay my investors a dividend of $2/share.

As soon as we pay that dividend, the stock price immediately drops to $98. My shareholders now have a $98 share plus $2 cash. Why does the price drop? Because the market is smart enough to realize my CEO wallet at $BEST is now $2 lighter. Seriously. It’s that simple.

The shareholders got their dividend *at the cost* of capital growth. Without the dividend, the stock price would still be $100. Remember our vital point from earlier: all investors’ total returns are a function of earnings.

If you use earnings to pay a dividend, you’ll have fewer earnings to fund capital growth. The pie is finite.

Dividends do NOT create money out of thin air. You can’t have your cake (pie?!) and eat it too. There’s no “free lunch.”

Bad Logic #2: “But I don’t keep the dividend! I re-invest it.”

Re-investing your dividends is a terrific idea for any long-term investor. It’s an essential gear in the compound interest engine. Vroom vroom!

But it’s not a special feature for dividend investing. Once again, the math explains why.

In the example above (forgoing taxes, for now), you could re-invest your $2 dividend into $BEST and go back to owning $100 worth of the company. It’s just as if $BEST didn’t pay that dividend in the first place. Same math.

“But I own more shares now!”, argue the dividend investors. We’ll get to that.

When a company does not pay a dividend, they reinvest their earnings on your behalf.

Re-investing your dividends is mathematically equivalent to the company retaining its dividends. It’s exactly the same for the investor (again, not counting taxes for now).

That’s why “but I reinvest!” isn’t a differentiating argument for dividend investors.

Bad Logic #3: “Dividend Stocks Produce Unique Cash Flow”

As we’ve covered, dividends are a regular cash flow to investors. But is this cash flow a unique feature that non-dividend stocks can’t replicate?

No. It’s not unique. Once again, there’s nothing special about dividend stocks here.

Rather than accepting a $2 dividend from $BEST, imagine a parallel universe where shareholders say, “Don’t pay me the dividend. Keep the stock at $100. If I need cash, I’ll just sell $2 worth of stock.”

That investor could sell 2% of their shares and have $98 in $BEST and $2 in cash. Same. Exact. Math.

The only difference would be in the taxation. Dividends and capital gains are taxed differently. All things being equal, however, dividend taxes are worse than capital gains taxes. It’s another strike against dividend investing.

Sidebar: “But You’re Diluting Your Shares!”

Dividend investors would argue my solution is bad because it dilutes my ownership. I had to sell 2% of my shares, whereas they don’t have to sell any shares. I now own less of the company.

This is yet another example of mathematical semantics. This Google sheet explains why. After 30 years, the two investors end up in the same exact spot.

A dividend investor will end up with more shares of lower-value stock, plus a pile of dividend cash. My suggestion (sell shares for cash) results in fewer shares of higher-value stock, plus an identical pile of capital gains cash. The final dollar values (# of shares times the price per share) are identical.

What’s more valuable—one $100 bill or a hundred $1 bills?

Dividend investors claim they’d rather have the bigger pile of paper. Let that sink in…

Bad Logic #4: “But I own my dividend stocks in a tax-efficient account!”

Owning dividend stocks in a tax-efficient account (401k, Roth account, etc) is terrific! It really is. It’s just as terrific as owning *any other stocks* in a tax-efficient account.

This argument highlights the benefits of tax-efficient accounts.

It doesn’t highlight any special features for dividend stocks.

Bad Logic #5: “I’ll never sell, and that income will keep rolling in!”

This argument is that their dividends will continue forever, an inimitable fountain of cash. But companies are free to change their dividends at their discretion. And they will when times are bad.

Future dividends are anything but promised.

Not to mention, we can choose to “never sell” our non-dividend stocks and create the same exact cash flow, as described in #3.

Bad Logic #6: “Look at how high the dividend is! Must be a great company!”

Some great companies (Amazon, Berkshire) have zero dividends. Some terrible companies use their death rattle to raise huge dividends, begging suckers to invest in their shares.

There’s no correlation between the soundness of an investment and the presence or size of dividend payments.

So, Dividends Stocks Are Bad…Right?

I’m not saying dividend stocks are bad. I’m just saying they aren’t special.

And dividend investing, as a practice, is built upon the foundation that dividend stocks are special. If build your philosophy on a false premise, you get a bad philosophy. As my rural brethren say, “You plant corn, you get corn.”

I own hundreds of dividend stocks within my diversified portfolio. Index funds are chock full of dividend stocks. But neither I nor those index funds hold those stocks strictly because of the dividends. We hold them because the companies they represent will grow over the next few decades. It’s that simple.

Dividends stocks are fine. Dirt bikes are too. But there’s no free lunch.

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6 thoughts on “No Free Lunch: The Truth About Dividend Investing”

  1. Great summary Jesse!

    While I enjoy the concept of dividend investing for some short term investing goals, we could easily sell shares and experience the same benefits (as you say).

    It’s always fun to challenge the norm. Makes for a fun debate!

    1. Andy Hill, welcome to The Best Interest my friend!! So cool to see you here. Thanks for reading and for the nice comment.

      Exactly like you said – it’s a fine concept, but not a superior one!

      Hope all is well with you.


  2. I agree with Andy a great summary and well explained. I have a buddy that believes that buying stocks with high dividends yields is a better way of stock picking as you know what your income/return is going to be. I will send him the link to read this. He loves dirt bikes so maybe that will be the hook to get him to read. I have unsuccessfully tried to explain to him that my index funds which has a low yield are no worse than high dividend stocks. I am hoping your explanation will finally click.

  3. Nice article Jesse. I haven’t tackled this topic yet myself but you did a nice job addressing some of the big areas of misinformation.

    Some other areas that I would point out:
    1. If you invest in individual dividend stocks you add the difficulty of stock picking. You also add individual company risk.
    2. High dividend stocks are a small subset of the total market so you’re now concentrated.
    3. Dividend stocks often underperform the index when I’ve run back tests.
    4. Some dividend investors think that it’s the solution to sequence of returns risk. I never have to sell, so I’m good!
    5. Some dividend investors think they can get to FI quicker. I just need a portfolio of 4% dividends on average and then by the 4% rule I’m set for life!

    The last two I may tackle in articles some day. I don’t want people to go down a bad path.

    1. I would be very interested in reading your insight on those last two points. I hope you do a post on it. I will keep an eye out for it Mr. MFI!

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