Should I Buy Dividend Stocks for Income? Is that better than bonds?
If you read anything from the Financial Pornography Network (God forbid), you may see articles like the stupid one I saw on MarketWatch article on buying stocks for dividend income. The author pointed out that the dividend yield of the S&P 500 is 1.8% and not guaranteed. Even the S&P 500 Value Index is only supposed to pay 2.7%. Bonds pay much more and are paid first. Therefore, be careful about buying stocks for dividend income.
Articles like these are problematic in that they don’t tell the whole story. It will lead DIY investors to false conclusions. It’s the problem of Self-Directed Education, which I covered briefly way back in Episode 7 on the Seven Pillars of Victory, and then expanded in my book, 3D Retirement Income. People “learn by Googling” and end up with disjointed facts and incomplete pictures. Do not invest based on random facts. Get a plan!
Let’s unpack this question and cover the following points,
Should I Buy Dividend Stocks for Income
Let’s start at the beginning.
What are Dividend Stocks?
There are two ways to make money by owning the best businesses in the world.
- Appreciation: The value of your share in the company grows over time.
- Dividends: When the company makes a profit and pays it back to the owners of the company as a dividend.
Growth vs. Value Companies
Companies will focus on different success metrics.
Some companies want to grow larger. When these companies earn a profit, they reinvest those profits back into the business to keep growing. They pay little to no dividends, but the value of the company, and thus your share of it, often grows faster over time. these are Growth Companies, and owning a share of them means you own Growth Stocks.
Other companies are generally okay with their size. They may grow, but more than that, they want to be a good value to their owners (shareholders). These companies tend to pay out more of their profits in dividends. These are often called Value Companies (Value Stocks).
A buying a value company, or a fund of value companies like the S&P 500 Value Index, will often pay higher dividends than other companies or funds.
What is a Dividend Yield?
Equity funds (stock funds) almost always pay a dividend. While no company guarantees it will pay a dividend, any more than they can guarantee they will make a profit, if you have 500 of the best businesses in the world grouped together, at least some of them will be profitable in any given quarter and pay some of that out. The cash dividend of the S&P 500 has never been zero.
These dividends are paid in cash, and there will be a certain amount paid. If you divide the cash dividend by the price, you get the dividend yield.
For example, the S&P 500 had a price of $3,585 at the end of September. The cash dividend was $65 over the last 12 months. That comes out to a dividend yield of 1.8%.
Yield vs. Interest
You could compare yield to interest rate (though they are not the same). If you bought the S&P 500 at $3,585 and it paid the same dividends over the year, you would get paid $65 and will have made 1.8% in dividend income. If you put $3,585 into a 12-month CD at 1.8%, you also would make $65, but in interest income.
You could probably get a 3-5% rate on a CD right now. 4% on that same $3,585 would be $143 in interest income.
This is where the naive will look at it and say, “If I can get a 4%+ in interest income, but only 1.8% in dividend income, then I should buy bonds!”
This is not the whole story.
Appreciate the Yield
You have to appreciate dividend yield. I don’t mean like or enjoy it, though you will by the end. I mean, you need to appreciate it, as in, grow the yield.
Remember, dividends are only half of the equation. The value of owning the best businesses in the world is the profit dividends and the rise in the value of our equity ownership in the company. This is the total return.
S&P 500 Growth of Dividends
Let’s compare some numbers for the S&P 500 over thirty years.
1992 S&P 500
(Numbers are rounded.)
|Earnings Per Share||$21|
|Consumer Price Index||140|
Some observations on those 1992 numbers.
- The price of the S&P 500 was $417. We’ll come back to that.
- The Dividend Yield was 4.58%. The 30-Year treasury rate was 7.67%.
You could get a better interest rate than dividend yield in both 1992 and 2022. But let’s see where this goes over those thirty years.
2022 S&P 500
|Earnings Per Share||$21||$192||9.2x|
|Consumer Price Index||140|
The S&P 500’s price has appreciated to 8.6x what it was thirty years ago.
Why is that?
The biggest and best businesses in America earn 9.2x more now than in 1992, per share. Equity appreciation is not arbitrary. It may not always follow exact metrics due to the human element. But over time, it conforms to real metrics.
While there has been more of a focus on growth than dividends, the cash dividend has more than tripled. The yield may have decreased, but not the cash. A smaller slice of a much greater pie is still a larger slice.
Dividend Income Vs. Bond Yield
Consider, then if we had invested $100,000 in 1992 in either the S&P 500, or a 30-year bond with an 8% interest rate.
- 1992 Bond Income: $8,000
- 1992 Dividend Income: $4,600
Bonds beat dividendends. Right? That’s almost twice the income!
But what about thirty years later, in 2022.
- 2022 Bond Income: $8,000
- 2022 Dividend Income: $15,600
When your 30-year bond matures, you get your $100,000 back. Meanwhile, the $100,000 invested in the S&P 500 has grown to $860,000.
Bonds don’t beat dividends. Bonds bomb, as covered in episode 60.
Dividend Income vs. Inflation
Let’s finish the table.
|Earnings Per Share||$21||$192||9.2x|
|Consumer Price Index||140||294||2.1x|
Over those thirty years, the cost of everything you need and want to buy more than doubled.
But your cash dividend more than tripled. All while your bond interest coupon would have remained the same.
Is $100,000 still worth $100,000 thirty years later? No. Bond income is fixed. Dividend income compounds.
The appreciating cash dividend of the best businesses in the world is the ultimate inflation killer.
Total Return vs. Current Yield
Never confuse current yield with total return. Not only would your cash dividend growth beat inflation growth by 60%, don’t forget that, once again, the value of your companies octupled.
It is not merely the dividend that we are invested in. It is the appreciation as well. The total return is your dividends plus appreciation.
This is why we don’t buy dividend stocks with the highest current or expected yield. Yield is only part of the equation.
We found a client whose advisor had stuck him in a dividend stock because of its high current yield. The current yield had remained high, but the value of the stock had declined by half over the last ten years. And the advisor did nothing! This is called “reaching for yield,” and it ignores the total return in favor of gazing at the current yield.
“More money has been lost reaching for yield than at the point of a gun.”
Should I Buy Dividend Stocks for Income? Really?
Invest, as part of a plan, for total return, not current income. Your investing plan should include dividend stocks, as well as growth stocks and a variety of other ways to slice it.
The cash dividend of the best business in the world is a powerful compounding device that beats bonds and inflation. And it’s only part of the total return. Make sure you get all of it.
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This article is educational only and is not intended to be investment, legal, or tax advice or recommendations, whether direct or incidental. Again, this is not investment advice. Consult your financial, tax, and legal professionals for specific advice related to your specific situation. Never take investment advice from someone who doesn’t know you and your specific situation. All opinions expressed in this article are the opinions of the people expressing them. Any performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be directly invested in.