From time-to-time, growth stocks are all the rage. The 1990s were one of those periods. Dividend stocks performed miserably for several years while newfangled internet companies with often little to no revenue, let alone profits, soared to nosebleed levels. The fact that a stock’s price went up yesterday was enough to entice so-called investors (read: speculators) to place their bets that prices would march ever higher tomorrow. We all know how badly that movie ended with hundreds of companies quickly crashing to zero, wiping out much of the same investors’ life savings who months earlier were crowing how they were going to retire at age 45.
Meanwhile, over the next 10 years – the ‘Lost Decade’ of the 00s – value stocks largely climbed upwards (while many non-dividend paying growth stocks cratered) with those invested in dividend payers collecting profits regularly and seeing their accounts continue to grow slowly but steadily.
The last three years have seen growth stocks again at the forefront, but the question is, now that interest rates appear to be on the decline, how might dividend paying stocks perform in the decade ahead? So far this year, dividend paying stocks have materially outperformed non-dividend paying stocks.
During phases when growth stocks are outperforming, it is tempting to go ‘all in’ and invest your entire portfolio into the latest tech companies which seem to defy traditional valuation metrics (the most dangerous four words in investing: “This time it’s different…”). Having some exposure to high quality growth stocks is certainly viable if you have a long enough time horizon to withstand the inevitable crashes along the way. But maintaining a core holding of dividend paying stocks is prudent for a variety of reasons:
- Dividends have represented upwards of 50% of total returns of the S&P 500 over time. When you factor in the reinvestment of dividends and compounding over long periods, this number gets even higher. Simply put, dividends are a very important source of overall portfolio returns.
- During market declines, dividends may be the sole source of profits (unless you work with a Financial Advisor who uses options as an additional means of potential profits). For those who don’t need the income in the near term, the reinvestment of dividends at lower prices can be a great source of higher future profits and income. This phenomenon does not occur for non-dividend paying growth stocks.
- Statistically speaking, dividend paying value stocks tend to decline less than their high-flying P/E growth brethren during market corrections.
- For those in retirement in need of regular income to pay for monthly expenses, the receipt of dividends allows investors to cover those outlays without having to sell stock and incur capital gains taxes.
- When you let dividends reinvest and compound over years, your effective yield (the income you are receiving today divided by your original purchase price) can reach double digits in under a decade in many cases. As a rule of thumb, investors typically withdraw 4% - 6% of their retirement account annually. Often the income from reinvested dividend stocks alone can more than cover this withdrawal need.
- Dividends are taxed at lower rates than most other forms of income.
- Companies that have a long history of paying – and especially raising – dividends tend to have a culture of financial discipline since the last thing they want to do is to cut their dividend during challenging times. This financial discipline has led, in aggregate, to the outperformance of dividend paying stocks over non-dividend payers within the S&P 500 over long periods. Remember, it is the fact that a company can pay a dividend (quarter after quarter, year after year), not that it does, that really matters since there is a strong correlation between ever-increasing dividends and ever-increasing profits.
It is difficult not to follow the crowd, especially when it seems to be raining money on them. Given the myriad potential advantages in the near and long term to owning dividend paying stocks, don’t give up on your slow and steady payers – the ‘compounders’, especially as we potentially enter a lower interest rate environment.