A popular strategy being mentioned currently in the financial press is to seek out high dividend paying stocks to increase your portfolio’s yield. Does earning a higher yield provide a safer, more reliable investment strategy?
To start, if a portfolio maintains a diversified U.S. and international stock allocation it will include dividend paying stocks. So an investor will already have an allocation to them in their portfolio. However, if an investor wants to move to heavily weight or exclusively hold dividend paying stocks, their portfolio would represent roughly 20% of the total U.S. stock market. This severely reduces the equity allocation’s diversification and therefore increases its risk level. In an attempt to make the portfolio “safer” by focusing on dividends, the portfolio actually becomes more risky.
The riskiness of a dividend focused strategy can be viewed another way. There are 320 funds in Morningstar’s universe of large cap funds that have a higher dividend yield than the S&P 500. Of those funds, 71% are large cap value funds. Thus, value stocks tend to pay higher dividends. This stands to reason as stocks that have high dividend yields have dividends that are a greater percentage of their stock prices and therefore their stock prices tend to be lower. Stocks with a lower price also tend to have a lower price to earnings ratio. If two stocks have the same earnings level, but one has a lower stock price, the cheaper stock would have a lower P/E ratio. Stocks with low P/E ratios, or lower than the market average, are known as value stocks. Value stocks are more risky given their standard deviation has historically been higher. Comparing the standard deviation of a Large Cap Value Index* with a Large Cap Neutral Index** shows that the value focused benchmark has a standard deviation 16.30%, while the neutral benchmark’s standard deviation is 15.80%. The value benchmark, which has a higher dividend yield, also has a higher standard deviation and is therefore more risky.
In addition, excluding companies that do not pay dividends from a portfolio’s holdings could result in missing out on a stock that could have great future growth potential and pay dividends in the future. A company that does not issue dividends can reinvest the earnings into the company and increase its value, which then increases the value of a stock holder’s shares. Cisco Systems did not offer a dividend from the time of its IPO in 1990 until March of 2011. Over that time the company grew massively. If an investor purchased 100 shares of the stock at its IPO and held it through March 2011 (when Cisco began issuing dividends) they would have had a cumulative gain of $507K. An investment fund focusing on dividends would likely have avoided investing in this stock and thus would have missed out on its immense return.
We take a total return approach to investing, seeking to maximize return from both asset appreciation and dividends and income on a risk adjusted basis. Yield only makes up a portion of investment returns. An investor should be focused on the performance of their total portfolio.
Looking at historical data supports this view. Over the last 30 years a portfolio of dividend paying U.S. stocks has had an annualized total return of 12.15%, while a portfolio with a broad U.S. stock allocation had an annualized total return of 12.31%.
By focusing intensely on yield, it is unlikely an investor will receive the most from their investments at the end of the day. Instead, diversifying your portfolio is the best way to reduce risks and position it for long term growth.
*Fama/French US Large Value Research Index
** Fama/French US Large Neutral Research Index
Index Performance July YTD Trailing 1 Yr
US Stock (Russell 3000) 0.99% 10.40% 7.33%
Foreign Stock (FTSE AW ex US) 1.49% 4.69% -11.96%
Total US Bond Mkt. (BarCap Aggregate) 1.38% 3.78% 7.25%
Short US Gov. Bonds (BarCap Gov 1-5 Yr) 0.39% 0.85% 1.86%
Municipal Bonds (BarCap 1-10yr Muni) 0.92% 2.75% 6.28%
Cash (ML 3Month T-Bill) 0.01% 0.05% 0.07%