The Dividend Income Illusion.

So, you want to live off dividend income only. Most people who want this believe they are not touching their principal (capital) when they do this. This essentially is a version of living off the interest and leaving principal alone. But …. that’s not true … that’s not what happens when you invest in dividend paying stocks.

When a company pays a dividend, their share price goes down by the amount of the dividend (share price also adjusts for market movements that day, so it is hard to see a penny-to-penny correlation, but it is there). There is also the illusion of income versus capital that has puzzled those who know how dividends affect the stock price (meaning your capital) as just explained.

This excellent article (CanadianCouchPotato) explains both of these effects.* Dr Meir Statman refers to how people just don’t believe this illusion in this article.

Walter Updegrave (cnnmoney.com October 5, 2012)explains how this works in an excellent article “Living Off Dividend Income” sparked by a reader’s question: “I’d like to live off dividend income when I retire. How should I invest my portfolio?”

Fama/French (2 well known economists in the academic arena) explain also that trying to apply this approach distorts your investing such that you become concentrated in just those companies that pay dividends … thus, you are NOT diversified with your portfolio. A broad diversification is extremely important so your portfolio has a better chance to withstand the many changing market environments you will experience during your remaining retirement years.

Dividend only? First, you are spending principal when you do this, contrary to the common illusion about how this strategy works. Second, you are increasing your portfolio’s risk through lack of a broader diversification.

So how should you take income from your retirement portfolio? Through Total Return. Money does not know how it was created, either through a gain or through interest or dividends. It spends the same. By accepting some fluctuation in principal value, you actually may provide a greater chance your portfolio can generate money longer than you live (as opposed to running out of money before life). The article series that are linked to (bottom of the article in this linked article) explain how total return and distribution research work together in retirement.

 

*The article in Canadian Couchpotato also refers to Dr Meir Statman, a behavioral economist, who I also refer to in other blogs. His work is quite interesting as he uncovers how we think and act in relation to money.

Note: Some confuse the term Synthetic Dividend with the term Homemade Dividend (which is the concept most closely related to Total Return, and the concepts discussed in this blog post).

About Larry Frank, Sr.

Larry R Frank Sr., MBA, CFP®, is an experienced financial advisor and a published author on Retirement Planning Research. Have a financial question? Ask Larry!

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7 Responses to The Dividend Income Illusion.

  1. Joshy K March 29, 2013 at 8:46 am #

    I agree with your premise only in part. If you have a portfolio of Solid Dividend paying stocks that either consistently maintain or grow their dividends, then the fluctuations in the share price does not matter, as the investor gets paid depending on the number of shares he/she holds. For example if an investor holds 10000 shares consisting of 20 stocks ( with as much diversification as possible) and gets $20,0000 paid annually in dividends. if the stocks in the portfolio are stable or growing dividend payers, the investor can expect to receive at least $20,000 in Dividend the next year and beyond. The total portfolio market value may fluctuate from month to month or year to year.
    I have held stocks (worth about $465,000 in 25 positions in one portfolio that I manage for a relative) in 2006 that pays about $21,000 in dividends per year. I have withdrawn $20,000 every year since 2006. The market value of the portfolio is now approximately $500,000 and yielding annual dividends of about $23,000. Therefore, not only my portfolio has grown from $465,000 to $ 500,000, the dividends have also grown from about $21, 000 to $ 23, 000. Yes during this 6 plus years the market value of the portfolio have fluctuated, but the dividend pay have never decreased even one $. This has been essentially a buy and hold investment without any addition to the portfolio.

    I agree with you that while screening for stocks that pay stable or growing dividends, it would also be wise to have as much diversification as possible. Based on a six plus years performance, I believe that it is possible to reap stable or growing income from Dividend paying stocks, if you choose the stocks with some discipline.

  2. My Own Advisor March 29, 2013 at 9:33 am #

    Hi Larry, good article, to a point.

    You are assuming some investors are ONLY invested in dividend paying stocks AND in small numbers.

    If I happen to hold a portfolio of 40+ dividend paying stocks, I’m not sure this argument holds true.

    Buffett doesn’t hold this many, and he seems to be doing just fine.

    Mark

  3. Larry Frank, Sr. March 29, 2013 at 10:36 am #

    Both good responses. For other reader’s education, I would point out a few things that my blog-site point of view represent:

    1) Picking your own holdings means you are actively managing your “fund” on your own, which is essentially the same as someone else actively managing a mutual fund for multiple investors by picking the fund holdings. http://en.wikipedia.org/wiki/Active_management

    2) My perspective comes from a passive management approach a.k.a.a form of indexing http://en.wikipedia.org/wiki/Passive_management since academic (French/Fama mentioned in blog) and S&P research http://us.spindices.com/resource-center/thought-leadership/spiva/ suggests that persistence (see persistence report) is a problem with active management.

    3) Persistence is important because retirees need to depend on having a source of income throughout their life in all forms of market and economic times with risks spread very broadly; rather than what seems to work for short periods of time. Research can separate timing effects and identify skill vs luck. http://www.dimensional.com/famafrench/2010/10/qa-when-does-active-management-shine.html (disclosure: I use DFA managed funds with clients who want portfolio management). Forum is available elsewhere, like http://www.moneyscience.com/pg/newsfeeds/Admin/feed/2344/blog-fama-french-forum , however tends not to include their earlier posts.

    4) Relying on just one type of income ignores the other types of income that are also possible … a Total Return approach recognizes all sources of spendable money http://en.wikipedia.org/wiki/Total_return which may become important especially in older retirement ages when they can spend some principal (and gains) because expected longevity is shorter.

    Are there other philosophical points of view? Yes. My blog in general expresses the philosophical approach of Total Return combined with passive management based on academic and peer reviewed research. This disctinction is important for those who choose NOT to manage their money on their own.

  4. Larry Frank, Sr. March 30, 2013 at 4:07 am #

    A lot of the comments I’m getting to this blog, via the Ask Larry link, are also getting the “destination” (your goal) consfused with the “fuel” (investing) for the “plan” (how you connect where you are to your goal).

    To unravel the differences between those please see this blog:
    http://blog.betterfinancialeducation.com/behavior-corner/im-a-planner-not-a-prophet/

  5. Larry Frank, Sr. April 17, 2013 at 10:42 am #

    Here’s a great 45 minute video at morningstar that discusses the problem with focusing just on dividends and how total return works
    http://wpfau.blogspot.com/2013/04/ameriks-and-evensky-on-retirement-income.html?utm_source=feedburner&utm_medium=email&utm_campaign=Feed%3A+PensionsRetirementPlanningAndEconomicsBlog+%28Wade+Pfau+-+Retirement+Researcher+Blog%29

  6. Larry Frank, Sr. May 2, 2013 at 3:29 am #

    Comments for this post have been deactivated.

Trackbacks/Pingbacks

  1. Weekend Reading for Financial Planners (Mar 30-31) - Kitces | Nerd's Eye View - April 3, 2013

    […] The Dividend Income Illusion – This article on the blog of Larry Frank provides some interesting thoughts about the caveats and problems of clients who are too dividend-centric in their investing. The primary issue is the so-called "dividend income illusion" – the fact that as dividends are paid, stock prices adjust downwards for the payment of the dividend, which means you're really not "saving the principle and spending the income" but actually just spending pieces of the principal as they're force-distributed to the investor! However, since most dividends are fairly modest relative to the magnitude of even daily market volatility, investors rarely notice this phenomenon – thus the "illusion" of it. In addition, the problem with dividend-centric investing is that dividends are paid far more in some industries than others, which means focusing too much on dividends ends out reducing the diversification of the portfolio (as investors in high-dividend-paying financial stocks sadly discovered in 2008!). The bottom line: dividend only is actually a principal-spending strategy, and one that can leave the client less diversified, so Frank advocates a total return approach instead. […]

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