Should I buy dividend stocks?

A simple question, right? But you know me -- I love giving complicated answers to simple questions. And this is definitely one of those times when it's worth peeling back the onion a bit. Let's talk about why we own stocks and why we would care whether it generates dividends, and then come back to the question.

Why own stocks?

Why own stocks? Why build a company? Why own a piece of a company? An easy intuition would be this: for a share of the profits. At the end of the day, that's the only thing you can use a company -- or a share of one -- for, right? You can't eat it. You can't sleep in it. You can't drive it to work. All you can do is make money from it.

But there are two ways to make money from owning a company. It doesn't matter whether we're talking about a company you've built yourself or one that you've bought a share in: you make money by taking some of its profits, but you can also make money by selling it at a profit. Startup companies in particular do this all the time; they're often built from the ground up specifically to be sold (eventually, ideally) to a larger company!

Investment real estate also works the same way: you can buy a building to make money off the tenant lease or rents, or to improve and "flip" it, or (as is often the case) both. "Income" and "capital appreciation" are both equally valid ways of making money.

So: you own stocks (and bonds and real estate) to make money, via capital appreciation or income. Dividend stocks give you income; why might that be better than relying on capital appreciation? There are two potential reasons this might be true: if you're looking for literal cash flow income, or if the fact that a stock produces income somehow makes it perform better as an investment.

Income investing

If you're specifically looking for investments to generate "passive income" for cash flow purposes, then it makes sense that dividend stocks would be attractive. But the question then becomes this: why are you looking for "passive income"?

If you want to improve your monthly standard of living (or maintain it once you retire), then all you need is either cash or something you can convert into cash on a monthly basis. So rents and dividends work for this, but any liquid asset also works -- which also includes stocks, ETF's, and mutual funds. Real estate, individual bonds, and other illiquid assets don't work (though the cash they generate does).

So really, what you're looking for is either liquidity or income, not just income. Think of it this way: if a liquid asset grows by 5% and then you sell off those gains, the result is exactly the same as if it had given you 5% of its value in cash! In fact, if the gains were taxed as long-term capital gains but the cash income taxed as ordinary income, it's actually better!

"But I want a steady stream of income," I hear you cry! "If I sell 5% of an investment each year, and that investment's value fluctuates, then it's not a steady stream!" This is true; if you're looking for a steady stream of income, you'll likely look to sell off a flat dollar amount of the investments, rather than a percent. The point, though, is that this is entirely under your control! Want more income? Sell more of the asset. Want less? Sell less. And if the asset generates income, you can choose to reinvest part of the cash (if you need less cash than it generated), or sell part of the asset (if you need more). Of course, if you sell too much, then eventually you'll sell off the entirety of the asset...but if you sell too little, then eventually you'll be sitting on a mountain of wealth that you never use! For most people, the object of the game isn't to die rich, but to live richly!

In other words: in the case of liquid assets, your income is what you make it, whether or not the asset itself generates income. What matters is that you set the income level at the right amount, not too much nor too little. So in the case of liquid assets, how much cash it generates -- or whether it generates any at all -- is irrelevant, barring taxes.

Performance of dividend-bearing stocks

The question then becomes: do dividend stocks outperform non-dividend stocks? A comprehensive answer was formulated back in 1961, from a paper by Merton Miller and Franco Modigliana. This paper's theorem is similar to the idea presented above: that investors should be indifferent to a dollar in capital gains versus a dollar in dividends, and that the price of a stock actually includes the value of future dividends. So the presence or absence of dividends should have no impact on long-term returns of a stock.

And is this true? Well, the paper garnered Miller a Nobel prize in 1990, so there's that. And so far, "dividend" hasn't made it to the short list of investment factors. (This hasn't much affected their popularity with investors, because "cash" is a lot easier to explain than "the value premium".)

As a case study, researcher Larry Swedroe took a look at two popular dividend-focused ETF's, NOBL and VIG. He looked at data going back to their inceptions, examined their exposure to various factors, and calculated their outperformance relative to their exposure to the factors. He found several things:

• Their performance is explained quite well by their exposure to the investment factors -- the R-Squared was 86% for NOBL and 94% for VIG.

• They did indeed somewhat outperform in down markets...and this, also, is explained by their exposure to factors. Specifically, they have a slightly low "beta" (lower movement up or down in response to the overall market), a somewhat high "quality" factor (more exposure to "defensive" stocks), and a negative "size" factor (more exposure to larger companies), all of which statistically lead to relative outperformance in down markets.

• Their overall outperformance net of factors and fees is negative; overall, these funds have actually underperformed over the course of their lifetime.

His conclusion: "consistent with economic theory - there is nothing special about dividends."

So...should I buy dividend stocks?

Given the above, when building portfolios, I don't focus on dividend stocks. I don't focus on non-dividend stocks, either, though! Mostly, I ignore the matter entirely...with one exception. When I'm looking at taxable accounts, non-qualified dividends can be a (literal) drag, because they're more tax-inefficient than long-term capital gains and qualified dividends. This plays a role in determining tax-efficient asset location, among other things. Other than that, though, I don't concern myself with whether a stock has dividends or not.

What I do concern myself with is: asset allocations that match risk tolerance and risk capacity, taking advantage of factors of increased returns, and ongoing optimization.

Britton is an engineer-turned-financial-planner in Austin, Texas. As such, he shies away from suits and commissions, and instead tends towards blue jeans, data-driven analysis, and a fee-only approach to financial planning.