6 Common Misconceptions About Dividends
During periods of low yields and market volatility, more than a few experts recommend dividend stocks and funds. This may sound like good advice, but unfortunately, it is often based on misconceptions and anecdotal evidence. Let's take a closer look at the six most common reasons why advisors and other experts recommend dividends and why, based on these reasons, such recommendations are often unsound advice.
Misconception #1: Dividends Are Good When Money Market Rates Are Low
There is no evidence that money market yields signal the right time to invest in dividend-focused mutual funds. In an October 22, 2009 article, financial guru Suze Orman recommended the following dividend funds: iShares Dow Jones Select Dividend Index (NYSE:DVY), WisdomTree Total Dividend (NYSE:DTD) & Vanguard High Dividend Yield Index (NYSE:VYM). The 12-month performance after Orman's recommendation was DVY (+7.86%), DTD (+21.91%), VYM (+17.72%). These returns seem pretty good - until you realize you could have just held on to the S&P 500, which was up +26.36% over the same period.
Misconception #2: Dividend Companies Are More Stable
It is generally believed that companies that raise their dividends over a long period have solid market positions and strong cash flow. As a result, the stocks' total return is likely to outpace other stocks. It's easy to pick a "solid" stock in retrospect but it is impossible to pick a company today that will meet this statement moving forward. Sure, if you had purchased Coke in 1962…but what about today? In 2007 we would have said that General Electric (NYSE:GE) and AIG (NYSE:AIG) were stable and well-managed dividend companies. Would we say the same in 2009? What about in the future?
Misconception #3: You Can Count On Dividends
Many people believe that it's rare for a solid company to suddenly reduce or rescind its dividend payment. "Solid" companies like Bank of America (NYSE:BAC), General Motors, Pfizer (NYSE:PFE) and GE, have either suspended or cut their dividends. Unfortunately, it is a lot easier to identify companies that had a solid record than to identify companies that will have a solid record going forward. It is impossible to predict which "solid" companies today are going to be on shaky ground tomorrow.
Misconception #4: Dividends Provide Upisde Potential/Downside Protection
A 2009 SPDR University brochure states that "Dividends provide a stable source of income that can help partially offset market price depreciation that occurs in turbulent markets." However, dividends provide very little - if any - downside protection during market corrections. The S&P 500 was down -41.82% during the September 2008 to March 2009 crash. During the same time, the SPDR S&P 500 Dividend ETF was down -35.87%, which doesn't seem like much downside protection. Additionally, some well-known, dividend-focused funds provided no downside protection and performed worse than the S&P 500 over this period.
Misconception #5: Tax Treatment Make Dividends More Attractive
This misconception seems to imply that dividend stocks are more attractive investments since they are taxed at a preferential rate. Does it mean you should avoid dividends in tax-deferred accounts since they are less attractive? Of course it doesn't. Then why should the tax treatment warrant dividend investments more attractive than capital gains? It doesn't, which is shown by the lack of any noticeable bounce in 2003 when the preferential tax law was implemented.
Misconception #6: Dividends Are Ideal For Retirees And Conservative Investors
An October 5, 2009, article in the Wall Street Journal stated that "Most types of fixed-rate bonds don't provide any protection against inflation and can lose value when investors are worried inflation will flare. Rising dividends, along with any appreciation in the share price of the company paying them, offer a measure of insurance against inflation." This statement is incredibly misleading. First, if you want a bond that protects against inflation, you can buy an I-bond instead of taking equity risk. Secondly, all equity investments provide a measure of protection against inflation, not just dividend stocks.