For those of you who don’t know Dan, he is an advocate for Index Investing, and his knowledge of this subject is extensive. His blog the Canadian Couch Potato is a fantastic resource for both the novice and experienced investor. Dan is also an accomplished author, and for more than 10 years he has contributed regular articles for Canada’s MoneySense magazine.
This interview is inspired from the Debunking Dividend Myths series which Dan wrote on his blog in January and February. To say the least, a flood of responses and lively debate quickly ensued with that series. During the sixth post, Dan had to grow a beard and wear sunglasses in public, to conceal his identity from stalking dividend investors.
This is the first half of my interview with Dan. You can read the second half of the interview here in Part 2.
The Dividend Ninja:
Hi Dan, First of all I wanted to say thank you so much for coming over to the Dividend Ninja and taking the time for this interview on Dividend Investing. I know you have a busy schedule, so thanks again! Have you recovered from all the debate on your Debunking Dividend Myths? I think many readers will appreciate the excellent research and insight you provided in these articles.
It’s my pleasure, Ninja. I learned a lot while researching and writing these posts, and from the feedback I got from readers. But I’m glad that the series is over and I’m back to writing about indexing!
Dan, over the last couple of years we have really seen the increase in the popularity of dividend investing. There are a lot more blogs (sorry I’m guilty of being one of them) and information available to the average investor on dividend investing. Do you think this is the result of the low interest rate environment we are in, and the attraction to dividend yield? Or are there other factors at play here?
Well, dividend-focused investment strategies are not new, but you’re right, they do seem to be more popular now. I think there are a couple of reasons for this. Certainly the low interest rates on bonds and GICs have prompted income-oriented investors to look more closely at dividends.
I also feel that many investors have lost their faith in the idea that they can rely on stocks for capital gains. In periods where growth stocks do well, dividend strategies can fall out of fashion and even look stodgy. We’ve certainly seen the pendulum swing in the opposite direction. Now we hear people saying they won’t even consider a stock that doesn’t pay a dividend, which I think is going too far.
More importantly, do you think investors are taking more risk than they should be under the umbrella of Dividend Blue Chips, as being safer and/or different than other growth investments?
Dividend-paying blue-chip stocks are not unusually risky. Indeed, as equity strategies go, they’re fairly conservative. The reason I wrote such a long series of posts was that I was reading and hearing a lot from investors who seemed to have fundamental misunderstandings about dividends.
On the most basic level, many seemed to look only at yield and ignore total return, which is really the only thing that matters at the end of the day. Others talked about dividend stocks as a substitute for bonds, or were looking at their yield on cost and thinking they were beating the market. Some thought that if two ETFs had different yields, the one with the higher yield was guaranteed to outperform.
At the end of the day, it’s none of my business what investing strategy anyone decides to use. However, I think you need to make sure you understand the strategy thoroughly, especially if you’re recommending it to others.
Dan, those are some good points. Throughout your Debunking Dividend Myths posts, you mention in your introduction that “many investors following a dividend-focused strategy may be better off with broad-based index funds.” So the issue comes down to passive index investing versus income oriented dividend investing. Are you convinced that passive index investing will provide investors with superior returns over dividend investing?
I would never say that I’m convinced that indexing will beat any active strategy: there will always be some strategies that outperform, even over a decade or more. The only thing I am convinced of — because the data are overwhelming — is that indexing offers the greatest likelihood of coming out ahead. It’s simply a question of probabilities.
It’s also important to consider asset allocation if you’re going to compare returns. An investor whose portfolio includes only dividend-paying stocks will likely outperform a balanced Index portfolio that includes fixed income. However, those higher returns will come with greater risk and much higher volatility. It would have little or nothing to do with the investor’s skill in identifying stocks: it would simply be a question of getting more exposure to the equity markets. (Putting 100% in a diversified all-equity index portfolio would likely do better still.)
Yet dividend investing provides you with the benefit of capital appreciation plus dividend income. Investors have seen huge capital appreciation of dividend paying stocks since 2008 to 2010 – with the additional dividend income. (Of course we have to realize that 2009 and 2010 were exceptional years for growth following 2008). So the premise that dividend paying stocks do not have the same capital appreciation as the overall broad market isn’t entirely correct. Your thoughts?
This is really the key point, isn’t it? There is this persistent belief that capital appreciation and dividend income are two unrelated sources of returns. But they both come out of the same earnings. If a company pays generous dividends, then it has less money to reinvest in its business, and therefore less opportunity for capital appreciation. Unless you think the dividends are created magically out of thin air, it has to be a trade-off. If a company pays out $50 million in dividends, then its market capitalization falls by $50 million.
If you’re a utility, with few opportunities for expansion, it makes sense to pay your investors cash dividends. If you’re Berkshire Hathaway (or Apple or Google), your shareholders are probably better off if you reinvest your cash in the company. Other companies can increase value by buying back shares*. As an investor in the broad market, you get access to all these types of companies.
That said, there are some convincing arguments about why dividend paying companies offer an advantage. I had several discussions with knowledgeable people who read the dividend series, and they made some excellent points which I am happy to acknowledge.
One is that companies that have a tradition of paying dividends are often more disciplined in how they spend their free cash. For example, if a company pays out half of its free cash in dividends, they have only half as much to reinvest in the business, and that forces the managers to focus on only their best ideas.
* There’s also a convincing argument that share buybacks may just offset the dilution that occurs when management is compensated with stock options, so it really doesn’t really benefit individual shareholders.
Dan, I know we have discussed the idea of the Core and Explore portfolio. The idea is to build a foundation of index funds and ETF’s and then add dividend paying stocks to that core over time. The concept being that if you pick a bad stock or two, you won’t suffer a huge loss in your overall portfolio. So if an investor really wants to invest in dividend stocks, and index investing is a proven strategy, why not do both? And what percentage would you advise an investor to keep the stock picking section of their portfolio?
I don’t have a problem with that strategy at all, so long as the expectations are clear. Someone using a core and explore strategy is still unlikely to outperform a purely passive strategy. (Author Rick Ferri like to call it “core and pay more.”) However, if you know that you simply don’t have the temperament to be an index investor, then in the long run you probably are better off if you use a combination of the two strategies. As I always say, the best investment strategy is the one you will adhere to over the long term.
What percentage should you allot to your stock-picking strategy? As little as possible, I guess. If you’re investing in both an RRSP and in a taxable account, it might make sense for you to hold your Canadian equities in the taxable account and use a dividend strategy there. (Obviously, you would have to compensate by holding fewer Canadian equities in your RRSP your overall asset allocation on target.)
Dan, thanks for taking the time out of your weekend and busy schedule!
Thanks for the interview, Ninja. It’s been a good opportunity to reflect on some of the ideas that came up in the repsonses to my posts.
In Part-2 of the interview I ask Dan about funding retirement through dividend income, the buy what you know strategy, and global diversification. You can read more of Dan’s writing, and learn more about passive index investing at the Canadian Couch Potato.
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