Sometimes writing this blog and interacting with the regular readers, forum moderators, financial professionals, and other bloggers it's easy for me to forget that the average level of financial literacy among docs, even extremely intelligent, talented physicians, is not that high. This usually becomes evident to me in curbside, real-life financial consultations, emails, or at speaking gigs.
I had a recent curbside discussion with a doc where it became evident the doctor didn't know the difference between investment “Yield” and “Return” and it seemed that a financial professional (okay, who are we trying to kid, he was a salesman of financial products) was taking advantage of that lack of knowledge.
Yield Does Not Equal Return
Here's the most important point — yield does not equal return. The yield of an investment is only one component of the return, the other one being the capital appreciation or capital gain. Bear in mind that either or both of these parts of a return can be positive or negative. Ideally, they're both positive and very positive at that. Yield is what an investment pays you in any given time period, typically one year. Capital appreciation is the difference between what an investment was worth a year ago and what it is worth now.
Let's run through some examples so you can understand what I'm talking about.
A Certificate of Deposit
Let's assume you buy a CD with a yield of 1.5%. The bank (and the FDIC) guarantees the principal won't go down in value. It also isn't going to go up in value, at least if you hold it the entire term.
Yield: 1.5%. Capital Appreciation: 0% Total Return: 1.5%
A Bond When Rates Increase
Now, let's say you buy a treasury bond with a yield of 3% and a duration of 5 years and interest rates go up 1%. The value of your bond falls 5%.
Yield: 3% Capital Appreciation: -5% Total Return -2%
A Bond When Rates Decrease
Now, let's assume the opposite occurs with that 3% bond, rates go down 1%. Now your bond is worth more.
Yield: 3% Capital Appreciation: 5% Total Return: 8%
Catch a Wave and you're sitting on top of the world. Early May is tough in Utah, you have to decide between water skiing and snow skiing.
Real Estate
Consider a paid-for investment property. Let's say your gross rents are $12,000 a year, and your expenses are $5,000 a year. Thus, your yield is $7000. If the value of the property at the beginning of the year was $100,000 at the beginning of the year, and $102,000 at the end of the year, then you get this:
Yield: 7% Capital Appreciation: 2% Total Return: 9%
If expenses one year were particularly high, it's quite possible your yield could be negative. That would mean you had to pour some money into the investment.
A Stock
Let's say you owned a share of Apple in 2014. It paid out dividends worth 1.67% of the share price that year.
Yield: 1.67% Capital Appreciation: 40.03% Total Return: 41.70%
In 2015, it wasn't nearly as exciting.
Yield: 1.93% Capital appreciation: – 2.80% Total Return: -0.87%
Reaching For Yield
People get in trouble when they engage in a practice called “reaching for yield.” This is when people invest in something just because the yield is higher, without paying any attention to the total return. As Will Rogers said, “I am not so much concerned with the return ON my capital as I am with the return OF my capital.”
A classic example might be a junk bond fund. Consider Vanguard's fund (which is actually very safe and well-run compared to most junk bond funds.) Back in 2000, a share was worth $7.32. It is now worth $5.69 (2016). Compare that to a safer bond fund, such as Vanguard's intermediate treasury fund, where the share value increased from $10.11 in 2000 to $11.58 today. Yes, the junk bond fund has a higher yield (currently 5.40% versus 1.15%) but that doesn't necessarily mean the total return will be higher because the junk bond fund is EXPECTED to go down in value over the years due to defaults, even in the falling interest rate environment that caused the treasury fund to actually increase in value. In this case, the junk bond fund has had a higher return than the treasury fund (6.34% to 5.12% per year over the last ten years) because the difference in yield was more than the difference in capital appreciation.
Dividend-focused stock investors are classic yield chasers. They choose stocks entirely based on the dividends they pay because they feel the dividends will be more stable than the stock price. The data actually looks pretty good in retrospect, but that's primarily due to the value effect, and it turns out there are better ways to get a high “value factor” than using dividends.
Even in “dividend investing” your total return is what really matters. You can always declare your own dividend by selling shares if you would prefer an investment where a larger percentage of the return comes from yield rather than capital appreciation. If you prefer the opposite, then just reinvest the dividends. In a tax-protected account, it's all the same. In a taxable account, you're actually better off with a lower-yielding investment most of the time on an after-tax basis.
My Curbside
Back to the curbside consult that started this post. In this case, a Wells Fargo “advisor” was pushing one of their proprietary products (with a wrap fee of 2%+) that was designed to be a high yield investment. This was their “multi-asset class income portfolio” that is composed of a bunch of investments selected primarily for their yield. These included stocks with a yield of as much as 4.34%, “business development companies” with a yield as high as 10.91%, master limited partnerships, REITs, preferred stocks, a couple of individual corporate bonds, and some bond ETFs you could buy yourself for 20 basis points.
Overall, it was about a 60/40 portfolio that seemed to be built primarily to be sold to someone who didn't know the difference between yield and return. The overall advertised yield was 4.14%. Of course, after you pay your 2%+ wrap fee, that's really 2.14%. Be careful what you ask for. If enough other people ask for it too, someone will make it and sell it to you.
Here's another example, also from Wells Fargo. It is called their “Multi-Sector Income Fund” that I just happened to run across while doing this post. It is a closed-end mutual fund with a high expense ratio of 1.24% and a current yield of 9.3%. That must be an awesome investment with that high yield, right? Well, if you look at the total returns for the last five years it has been 4.04% per year. That must be really disappointing to people who bought it thinking that because it had a yield of 9% that it would have a return of something like 9% (or more.)
Yield is not return. Return is not yield. Return is yield + appreciation (or depreciation.) Know the difference when evaluating investments.
What do you think? Have you or do you know someone who got burned reaching for yield? What happened? Comment below!
This was very helpful. Despite my reading this blog for about 2 years now and being halfway through my 3rd and 4th “financial books” right now, I somehow had never understood the difference. (Currently reading the millionaire next door and the intelligent investor) I saw the words yield and return tossed around a lot, but no one stopped to explain them. This is a nice, simple, clear set of examples. Thank you.
Me too. Might help explain this all to husband, who still thinks he got a yield of 20% one year when he cashed out a mutual fund for a new car (and later wanted me to put more of his money into that great fund that paid 20%).
Good reminder to those who look at dividends as the safe portion of their portfolio. Your yield can be phenomenal and still if the underlying asset declined your return will suck. Unfortunately so many people shift their investments to junk bonds and dividends in a low return world. High dividend stocks will be amongst the hardest hit and inflation again rears its head. Sadly I fear high dividend stocks may end up being the next mortgage backed security if they continue to be priced up. Have you seen the p/e on electric companies and other high yielder’s recently?
Nice post and review of an important but basic concept. A good explanation of one of the many, many ways that the financial services industry will use marketing, in this case in the form of terminology, to sell products to consumers. In my experience, investors are very susceptible to misunderstanding how to evaluate returns and this is successfully exploited by the financial services industry time and time again.
I am not defending the sales people who dish out financial advice at all. But I actually think lots of people who should understand this sort of financial math don’t… and gosh who knows the reason.
If you poke around one of the real investor forums, e.g., it sure appears to me that many of the “experienced” investors, agents, and self-appointed experts don’t understand the real estate flavor of this formula… that income capitalization rate (aka “cap rate” and aka “yield) plus the appreciation rate equals the project internal rate of return (aka “project IRR” and aka “return”)…
All the more reason to understand this fundamental concept, obviously, if one ventures away from a vanilla asset allocation formula based on cheap index funds.
What about the fact that companies that pay dividends, especially the dividend aristocrats index has outperformed the S&P? Why would that be if dividends didn’t mean anything? And what about in Jeremy Siegel’s book, Stocks for the Long Run, where he shows portfolios with higher dividend yields offered investors higher total returns than portfolios with lower dividend yields going back to 1957. The annual return of the 100 highest dividend yielders in the S&P index over the past 50 years was 3.78% per year higher than efficient markets model and the 100 lowest dividend yielders had a return of 1.68% per year lower!
According to James O’Shaughnessy, from 1951 to 1994, the 50 highest dividend yielding large cap stocks had a 1.7% per year higher return than the market.
I agree that Yield is not total return, but that doesn’t mean that good yielders can’t grow too as shown above
As noted in the post, those effects are primarily due to the value factor. There is lots of good data out there showing that, at least in the past, having a value tilt to the portfolio, whether you got it by investing in higher yielding stocks or not, resulted in higher returns. There is some arguing about whether that is a behavioral free lunch or compensation for taking more risk (I fall in that camp), but the data is what it is. Whether that has now been arbitraged away or not is a different question.
Whether you decide to get your value tilt by being a dividend focused investor or not, you need to understand the difference between yield and return, and that’s what this post is about.
Thank you for not saying “The data are what they are”. That’s a pet peeve of mine. I think we’ve moved on enough from Ancient Greek that we can claim data as a singular English noun.
The datas are what they are.
😉
-PoF
I understand what you are saying, but you can take data even more recently like the dividend aristocrats which have also outperformed. Not all these are value stocks, many of them are ridiculously overvalued, yet still outperform because the act of having a long history of dividends with a good yield does not necessarily mean it is a value stock, it just means that it is a darn good company that clearly is making money and is profitable and confident about its future when it keeps paying and raising dividends.
I get the point of the article is to explain to readers what total return is, but at the same time, it is not necessarily the fact the just because something has a good yield people should ignore and say “eh well its got a high yield so therefore capital appreciation won’t be that much so total return will only be average.” That is not always the case. And history has clearly shown that too. Thanks for the article and I appreciate your response to my comment!
Thats “reaching for yield” in action. People felt burned and toasted after the GFC, dividend investing and the aristocrats to the rescue! Its become a fad, like low volatility, or every other before it. The very thing that made it work has plausibly been arbitraged away (which is value). There are tons of firms with very high dividends that will absolutely burn your cash out of your account, people get tunnel vision and suffer from extreme survivorship bias in putting these back tests together.
Look at the revenues and earnings of many of these companies like Proctor and Gamble, they have been stagnant and declining yet the stock keeps climbing. Maybe a hiccup or not, but thats not what made it great in the past.
You can wildly overpay for a great quality company right? Taking your reasoning to extremes one has to ask what is overpriced, do you have a mechanism to determine when their is little upside left or too much downside to risk any capital? Irrational and herding happens, when extreme we call them bubbles and manias. Look at Microsoft, Cisco all these dot coms that barely breached their 15 y highs this year, they suffered from being overpriced even though they did nothing but increase revenue and profits in the interim time. What you pay matters in your return. Dont just believe nice stories, you have to see what actually made them happen, and overall circumstances may be wildly different now.
This is one of my favorite responses and a classic knee jerk reaction to try to disagree with a point and make yourself appear smart. I quoted documented academic statistics and you are just making things up and saying “what you think”. Obviously things can change, nobody knows the future, we don’t know how any of these companies will do in the future. Therefore given that reasoning, your explanation is moot anyway because you are just guessing, speculating, trying to rationalize.
So since we agree we don’t know what will happen in the future, what are our options? We could look at the past history of the stock market to see what has worked OR we could just assume everything is backtested and data mined, everything is arbitraged away, things that have worked in the past like dividends, momentum, value, small cap, all that’s useless, right? So you would rather just ignore the academic studies of things that worked and just do the opposite or some made up strategy with no history just because in your head you think things are different now? Hey, its your money, go for it sir, I will stick to the academics and what has worked for decades. And speaking of data mining, you picking just 2 dividend stocks that haven’t done that great does not prove anything, how about the other hundreds of decent yielding dividend stocks? Most outperformed the market very strongly. By the way PG pretty much had the same return as S&P over the past decade anyway.
And calling dividends a fad? Really? It’s one of the oldest and time tested strategies out there that has been around for decades. What are you even talking about? You are just guessing and making things up and trying to call a top to the market by saying its going down.
I know this is off the subject, but you mentioned low volatility. That is not necessarily a fad, it is just something that has been researched to show it has given good returns with reduced risk. And take a wild, crazy guess on which companies are included in low volatility indices? Gasp! It is mostly blue chip dividend growth stocks that have paid a good yield for decades. Not seeing a pattern yet? I understand people just don’t get it sometimes, you keep doing your thing, let’s compare returns in 20 years.
“a classic knee jerk reaction to try to disagree with a point and make yourself appear smart”
I’d tread carefully. Zaphod is plenty smart, particularly when it comes to investing theory and history. He is a frequent contributor here and on the forum. Fortunately, he is also rather polite.
+1
+2
Thank you for your concern, I will do my very best to tread carefully.
Don’t be so sensitive. I am just correcting him and saying it like it is. Sorry its not sugar coated enough for you. That is sweet of you to defend him though.
Unfortunately I don’t stalk the comments in any post, just had something to contribute to this one, so I have no knowledge (nor do I care) how smart someone is by their previous comments, I am discussing this topic and I feel he is wrong.
I was pointing about academic studies and decades of history and he just says “this is a fad, it is datamining, dividends are just bubbles, they won’t work in the future, its arbitraged away.” This is based on nothing, just his opinion which means nothing as I am talking about decades of academic studies. I will choose that and decades of a proven strategy rather than what one person’s opinion is in the comment sections of a blog. Hope that clears it up for you!
I actually think Zaphod makes the better argument here.
Also WCI’s whole point, I think, was to observe (very correctly in my experience) that many investors focus on the yield because that’s easy to see and then miss the return which is really all that matters.
2 opinions still doesn’t beat decades of academic studies. Amazing that a physician blog where most of us are doctors and used to evidence based medicine don’t use the same in finance. You are just stating your opinion too. And I think you’re wrong too. Over time who knows, anything can happen, but that’s the point, I don’t know any more than you, so your opinion doesn’t mean anything. I was just listing time tested, proven, evidence based academic studies to support my point. What EVIDENCE do you have. I am not interested in your made up analysis of how you think the market is and where it is going. That means nothing. What evidence do you have that you are right and I am wrong? That is my whole point.
You need to understand the difference between evidence based academic studies vs someone’s opinion. You agreeing with someone’s opinion does not prove anything. That is the blind leading the blind.
Good luck with your investing.
I had several of graduate school finance classes from one of the finance professors, Rex Thompson, who did early research into what you’re talking about.
http://www.smu.edu/Cox/Departments/FacultyDirectory/ThompsonRex
So it isn’t really opinion… I will admit, though, I was influenced by Prof Thompson’s assessments of the issues you feel passionately about.
I agree that just because something has a high yield doesn’t necessarily mean it doesn’t have significant capital appreciation or a solid return. But the opposite is something that happens all the time and should be watched for.
The Dividend Aristocrats strategy reminds me of The Dogs of the Dow strategy, which worked, until it didn’t.
Kyle I have a newbie question. I looked up VHDYX which is Vanguard high dividend yield index fund. When I compare it to SPY on morningstar they both look the same for last 10 years. I made sure to look at growth which includes yield instead of price.
Even 10 years is a short period when it comes to seeing the effect of a value or dividend tilt. Remember these effects are not huge, they’re really only reliable for long periods of time, and they aren’t guaranteed. You will see many 5 year periods where a value tilt didn’t pay off. Opponents argue that it’s just returning to the mean. Proponents argue it’s too short a time period. If you’re going to value tilt your portfolio in any manner (including dividends) you need to be convinced it is a good idea and you need to stay the course for a long, long time. Otherwise, stick with a total market approach. Far easier to deal with the tracking error when there isn’t any.
Dr. PK, I agree with WCI on this point. VHDYX was started in 2006. That is way too short to analyze any significant long term edge. Anything happens over the past 10 years. If you are using that short of a time frame, you could look at 2000-2010 and conclude the S&P is useless because it just went sideways and had <0.5% return. Of course that is not true, but that is the problem with such a short time frame, you can't make any reasonable conclusion. Check out the studies I quoted on my original post. Those are for longer periods of time which have shown to have an edge. Also, check out this:
http://us.spindices.com/indices/strategy/sp-500-dividend-aristocrats
Compare that index to the S&P 500 and over 10 years it has had a 3% per year higher annual return. Again, doesn't prove much, but just to answer your question.
Keep in mind traditional dividend investing has always been done with buying individual stocks. It is relatively new (last decade) that there have been dividend focused ETFs so it is tough to find a straight forward comparison, but again check out the studies I quoted above and you will find a lot of information about it.
Im just stating the obvious, you’re reading too far into it. You cant just grab the highest decile yielders and be guaranteed an above market return, or else we’d all do it. Yes, you then can say “quality” and point to dividend aristocrats, etc…and be more likely to do better, however lots has changed and things will not necessarily be the same going forward or maybe it will, who knows.
We have to remember that over those long term studies, even in the 80s and most of the 90s, the average investor did not have access to this data, the market, or the ability to invest at a moments notice. This is especially true the further you go back to where index investing did not exist, frictional costs were extreme, etc…
Just head over to Seeking Alpha and go to the dividend investor pages, it is basically a cult. A lot of factors have led to a boom in the “dividend mindset”, most notably two severe crashes in 10 years, and the low credit boom allowing companies to grow their dividends at speeds they mathematically can not replicate going forward save extreme growth which many of these companies are already large enough to make difficult.
Its just a probability thing. The reason it worked in the past was because they were relatively undervalued, that is no longer the case. How much upside is there vs. downside, thats always how I try to frame it. Seriously, early in my investing learning I was also a dividend believer, but it really comes down to price and how much you have. With enough principal it doesnt really matter. From a business standpoint, dividends are a horrible inefficient friction, and I wonder how they will respond in a more competitive world, ie, will business with less friction be more flexible, etc…
Another academic study showed that it didnt take long after studies found these anomalies that they were arbitraged away by eventual investor behavior. This is partially what has crushed hedge funds, people mock them now but they used to crush it return wise, but research kept identifying factors and everyone else without a research powerhouse team knew a valuable screen or factor.
Dividends are just a single factor, and itd be foolish to base a whole strategy on solely a single factor without weighing in the driving factors of why, when, etc…and how that applies to the current macro and business environment.
Lots of different strategies work or have worked in the past, some maintain and some dont.
If you use that reasoning though, then how is indexing any better? Indexing is “relatively” new in the grand scheme of things and now there is so much information about it and everyone says its the way to go, so everyone is pumping money into these funds in an already overvalued market. There is not much room to go up right? As opposed to sticking with companies that have an edge. That might be small cap, value, or dividend growth. I know this is the wrong forum to discuss anything but indexing so I won’t go there, but there is still plenty of value in finding individual companies with long dividend history that is undervalued. That is what those studies are based off of and that is how people invested for decades, not just buying one overvalued ETF, even if it was full of dividend growers. Anyway, please lets not get into the whole stock picking, uncompensated risk thing, I’m well aware and disagree with much of it, but lets stick to the topic…so how would indexing be any different using your reasoning?
Indexing is different because you’re accepting, and yes thats what you’re doing, accepting the market return however good or bad it is. Indexing over time benefits from every single factor as well as concentrating winners, while being as diversified as you can be. Not to mention the pure simplicity value, which is large.
The point you make above is most important in the “undervalued” comment. Many of the aristocrats have been bid up to a level that is higher than the average value of the market, which is what makes it fad like, its been bid up do to its past performance. The more its bid up the less likely it repeats that performance. There have been excellent times to buy blue chips and terrible times, its hard to know where we are right now of course. Will it be better again in the future? Yes, when too many people pile into it and all these dividend fire blogs think they won the lottery and get trounced in the ensuing sell off. When the Dividends Suck blogs start arising and the PE of blue chips is solidly less than the market than it will be an excellent strategy all over again. Everything depends on price, which Im sure is implicit in what you’re saying, Im however just saying the price is high which naturally limits your forward return.
If you bought CVX at 125 and I bought it at 100 within the same 6 month period one of us did better than the other. No matter how great a company or its solvency is you can always pay too much.
Low volatility is definitely fad like, you think those telecoms and utilities are worth those multiples in reality or its more likely that people were reaching for yield while telling themselves its “safe”. Dont get me wrong, I rode it for about 9 months, good trade.
I wont lecture you on risk (I trade volatility so am in no place to preach), but it is definitely real. Even if returns were higher, you were certainly taking on more risk than a mutual fund/etf and that makes sense right?
The whole point is that nobody knows what will happen. You are saying that by understanding why certain things performed better than others in the past, we are now smarter and just dismiss those things because the edge is arbitraged away. In a nutshell, you are trying to call a top. You are saying that dividend payers are so popular that there is no where to go but down. This has been shown to be a very unproductive exercise as you have no clue how far these stocks can go. Just because it is known they have done well the past several decades, now all of a sudden they won’t do as well? That is trying to call a top. Maybe what you are saying is true, but won’t actually happen for another 20 years. You might be kicking yourself in 20 years when these same stocks that have outperformed the market consistently for the past several decades continue to outperform it and it will be so obvious in the past you will wonder why you missed the boat. You will find that you talked yourself out of documented history and academic studies just because you had a bad feeling and you felt the market was overvalued and tried to call a top. So we can either listen to history or just throw our hands up and throw everything in the total market index and get some mediocre returns. When you look at the returns over decades and decades of small cap, value, dividend growth, the outperformance is so large and obvious it can add up to 7% return on top of the market. I’m sure you are smart enough to know how much a 1% increase in return makes over 20-30 years, imagine 7%? We are talking tens of millions of dollars. That is worth the “risk” to me. I put risk in quotations because it is tough to call something risky that has worked for the past 60 years and in many cases much more. I think worst case scenario, strategies like this may match the market. I find it hard to believe the total market index strategy is going to do so phenomenally well and all these other strategies with a clear edge in history will be so poor. Also, you are implying these dividend stocks are in a bubble. A bubble is when there is mania and people are buying things for way above their market value. That is not the case here, they may be popular, but recent reports have shown, the high prices are justified based on the value. That is not a bubble. A bubble is when people pay $87 for an internet stock that has no revenues like in 2000. That is not the same thing.
By the way, the total stock market index approach is exactly the same as just buying the large cap stocks anyway. It’s performance has been almost identical to S&P for decades. So you really think that dividend stocks or value or small cap is going to do so terrible but the S&P/total market index will be the winner in the end? If dividend stocks are down, the whole market is down (although ironically these dividend stocks have had less volatility as a whole compared to total market). I think its a free lunch. You will either do better or come close to matching the market.
And I agree with you that I’m sure dividend stocks will crash and suck and everyone will hate them at that point. That’s the cycle. That is with every strategy, it goes out of favor for certain market cycles. I am not refuting that, I never said they wouldn’t go down. I said over a long investing time horizon 20-50 years, they will come out a few % points ahead like they always have. I love to see them crash. I am picking up some great stocks now that have been sold off, going through a rough time and dropped way under their valuation. Will it underperform the total stock market index? Probably, maybe for a couple years, but most of the time they fire right back with a vengeance and in the mean time you collect a juicy yield. So to bring it back to the original purpose of the article, you not only get that juicy yield, but the capital appreciation ends up being just as much and many times more than the market and therefore your total return is much better. All this is going on because I still own those same number of shares and locked in a high yield. So when the capital appreciation starts and moves with the market or above it, it is icing on the cake. It is not always a trade off. That was my whole point.
“History doesn’t repeat itself, but it certainly does rhyme.”
I disagree that the value factor is a free lunch. I think it is compensation for additional risk. But reasonable people disagree on that. A dividend strategy is one method of getting the value factor, although Swedroe would argue, not the best method. (As I recall Price/Book was the best method he looked at.)
The large weighting of the dividend aristocrats and great companies in the indexes most would choose is exactly why there is no need to do much work at stock picking and basically the point. Yes it can be fun, and over time if you just held forever and they at least returned near market or better they would do great against even low ER funds.
Im not calling a top, just looking at the underlying reasons why those companies did what they did in the past, and how it matches todays conditions and what the relative probabilities for a similar magnitude out performance is. I think its enough different/unpredictable that Id rather just have an index that mixes them up.
I know the history and reasoning behind the dividend strategy, but disagree there isnt a trade off. There is always some trade off, even if its only your time, effort and management of it, which of course you may really enjoy at this time so its not a big deal. Life is all trade offs.
“Im not calling a top, just looking at the underlying reasons why those companies did what they did in the past, and how it matches todays conditions and what the relative probabilities for a similar magnitude out performance is”
That is calling a top Sir. You are just using different language. You are trying to analyze and reason and rationalize with the market. Many have done that before you and most fail. Millions of people are doing what you are doing now. It means nothing. Most will be wrong. Market is not that simple and no offense, but you are not that smart to correctly analyze the market and make a prediction about what will happen without there just being randomness and do this consistently for the next 40 years.
You are using opinion. Call it what you want, but that is what you are doing. I am just sticking with history for the last 80 years, I don’t make predictions.
You may be right. I may be right. But you are using no evidence, just making up an analysis in your head on where you think the market is going and why you think it behaved as it did in the past. Many are like you and do that all the time and they are wrong. Maybe get lucky once in a while, but over time they will never analyze the market correctly. Whereas I am using evidence based academic studies.
Let’s bookmark this page and meet up again here in 20-30 years and we will see who was correct 🙂
You’ve got a lot of faith in my ability to create a lasting institution.
But seriously, you two need to just agree to disagree and move on. Neither of you will ever convince the other of whatever it is you’re working so hard to do.
Newbie question here; can you explain the “value factor” or “value effect”? What does that mean, and how does that result in higher returns? Thanks
Consider the Morningstar “Box” that looks like a tic tac toe game. It divides stocks up into 9 different types. Left to right is value, blend, and growth. Top to bottom is large cap, mid cap, and small cap. The cap means capitalization, or the size of the company. Wal-mart is a large cap stock whereas Limitcom (I made that up, most small caps are companies you’ve never heard of that make one thing) is a small cap stock. A small cap stock is generally a riskier stock, and thus has higher potential returns. Wal-mart is also a growth stock- meaning a dominant company in its industry that everyone has heard of and that people expect to grow its earning rapidly by virtue of its wise management and dominant industry position. K-mart is a value stock- people expect it to go out of business because it’s run poorly, closing doors in many stores etc. Because nobody likes K-mart, people don’t want to own it, so you can buy it “on the cheap.” It turns out that over many years and many stocks, that buying these downtrodden companies no one likes results in higher returns than buying the flashy Disney, Apple, Wal-mart stocks. People simply pay too much for growth.
There are several different ways to determine which stocks are value stocks and which are growth stocks. One such way is to look at the dividend yield. Because the price is lower for each dollar of earnings with a value stock, they tend to have a higher dividend yield. So as a general rule, choosing stocks with high dividends results in a higher percentage of your portfolio being in value stocks than the overall market.
Hope that helps.
Mike, my opinion is this:
Dont concern your self with value or growth stocks. This or that. Sometimes growth stocks outperform value stock and other time value stocks do better. Additionally, no one really knows what is a value stock. Additionally many growth stock eventually become value stocks, and it is during this transition when most retail customers get their head handed to them. To make things a bit more scarier, many growth stocks just disappear / vanish / go to zilch.
So, for someone new to investing, just buy index fund for both stock / bonds, and rebalance every year. In 20 – 60 yrs, you will have done better tun 90% of investors.
Enjoy life.
90% of investors underperform the market because they are idiots who trade emotionally. They have no strategy and as soon as things get rough, they get spineless, sell everything for a loss and then try something else and repeat the same mistakes. They buy the hottest stocks going up hoping to make a fortune and buy it just in time for the market top and ready to ride the crash. Then they get scared at the bottom of the crash and sell.
If you have a proven strategy that has worked for 80 years like many of the strategies out there and stick to it, you can likely beat the market. It is true that sometimes growth is better than value or large cap is better than small or a total market does better than dividend strategy. Of course they rotate, but in the end there are clear winners as history shows. Why don’t most investment managers beat the market? Because they have other agendas. If they don’t outperform the market consistently and regularly, they will be out of the job and investors leave the fund. Most investors don’t understand patience or strategy they just go to the next big thing that is going up and buy just in time for the plummet. No investor will hang out a fund that has been underperforming the market for 3-5 years, heck they probably jump ship if it underperforms in 2 years. Think of how ridiculous that is. But many strategies have shown if you stick to it, you can beat the market.
For most part I agree with. Just about any sane strategy will have its day in the sun. However, what most investors need to do is to stop obsessing about beating the damn market. The most important thins is to truly know your risk tolerance and then stick with your asset allocation.
You see, Mr. market time horizon is infinite (well, you know what I mean). Most investors have to deal with a thing called life, including illness, loss of job, kids, college education, kids weddings, etc,
So, buy the entire stock market and adjust your risks, and you will do well
I disagree that there are many strategies that will beat the market going forward. Can I look at past data and choose some strategies that would have beaten the market in the past? Sure. But it is much more difficult to do prospectively.
With a slight majority of my portfolio in a taxable account, dividend yield only hurts my total return, due to tax drag. I see dividends as being force fed on a regular basis whether I’m hungry or not, regardless of the tax consequences.
As you point out, I can go to the cupboard when I’m hungry and create my own dividend by selling shares. I should start my own dividend focused blog. DownWithDividends.com.
Best,
-PoF
PoF,
Funny idea but please be careful of starting a “DownwithDividends.com” blog. I don’t know what it is about dividend stocks but some of the dividend enthusiasts out there are very adamant about their craft. Their focus reminds me of survivalists!
They’re not quite as bad as the whole life folks, but would benefit from first understanding how to be a “total return investor” before deciding they want a heavy dividend tilt.
So true, RocDoc. All the more reason to create the site. Nobody goes on the internet to agree with anyone anymore. 😉 Controversy sells!
I agree. Oh wait… I must not be on the internet ;>)
This notion of limiting dividends in a taxable account is a new one for me. I just realized that Vanguard made “Tax-Managed” TSM and Small funds for this purpose. I don’t think its worth selling current assets to switch into these funds, but for future contributions… Is this something other people are doing?
If you’re using index funds already, the additional benefit of the tax managed funds is pretty minor. To make things worse, the ER is sometimes higher and you may not like the stocks they are invested in anyway. For example, I think tax-managed international doesn’t include emerging market stocks like Total International Stock Index does. I certainly wouldn’t pay any capital gains taxes to switch from Total Stock Market to a tax-managed fund.
Excellent post that explains one reason finance doesn’t have to be as complicated as most firms attempt to portray it is. Successful investing ain’t brain surgery, folks.
I feel a bit stupid not knowing this either. What do you mean you can’t teach an ol dog new tricks? Thanks.
A few additions. For bonds if you hold them to maturity you do not have a loss. For dividend paying stocks if you do not sell and the dividend stay the same or increases gain or loss does not matter. Invest for your goals.
Lots of “ifs” there, which may or may not pan out. Many dividend focused stock investors were surprised to see how much dividends from companies that had never cut them were cut in the Global Financial Crisis. Here’s an article from 2009 which states
http://usatoday30.usatoday.com/money/markets/2009-12-23-dividends-down_N.htm
Bottom line: No guarantees, even with a dividend strategy.
How does a loss not matter? Who cares about a measly 3% dividend in the face of an 80% total return loss that may never resolve itself?
People always ignore that these strategies benefit from survivorship bias in their choices available and that really skews thins. Luckily an index does that for you.
Article was great…but the wakesurfing pic is even better! Thnx.
+1
Allright, enough of bantering back and forth without knowledge or experience by many posters
Reaching for yield by definition is bad (self explanatory)
However, dividends are good and if reinvested, account for majority of stock market reruns (I am not even talking about high yielders, just market as whole yield, which fluctuates
Someone posted that dividends are a “drag” on their returns due to tax consequences. R U kidding. Would you rather a business that does not have need for cash to just keep it and and waist it on (bonuses / mergers). Can you imagine the damage it can do to the company / stock. Lets not for get that qualified dividend ax rate is very low.
Now a confession. I absolutely reach for yield, and it is only worth reaching for once dividend paying stock go out of favor every few years. I have loaded up on MLP’s this year, have locked up > 24% yield / it is growing and stock prices have about doubled as well.
Another opportunity to by reits / mortgage reits / utilities and other high yielders is coming due to anticipated fed rate hike. Some of these stocks just made all time highs couple of months ago, and are now down 8 – 12 % on possible fed rate hike. However, I am going to wait for a while and pick up these nice fat juicy dividend payers over next 6 – 18 months. As fed raises rates, foolish investors / including large institutions are going to unload them like crazy.
Yes, I am a proud owner of multiple WLI. I think every young health individual should have them
Another classic in the Back to Basics series! Thanks for going back to these fundamental principles.
I wish Zaphod and Kyle continued their discussion. This is a classic disagreement between an index investor (or total return guy) and a dividend stock picker. Since I’m in both camps it was interesting to read. It all comes down to what YOU believe in: you don’t have time or consider it a waste of time or whatever reasons you choose, so you choose index investing or you enjoy your little hobby, have time and fun analyzing divvy aristocrats, champions, so you choose dividend investing (I’m not talking about dividend companies that pay 6% or more in this environment because I’d be considered high yield). Zaphod disagrees or dislikes DG investing now, so he calls dividend investors on Seeking Alpha a cult. In return, Dividend Investors call Bogleheads index cultists…so go figure…it all comes down to your own beliefs.
I honestly don’t even comprehend what value tilted is (wouldn’t be out of favor companies?). I think I understand growth a little better (Amazon, Tesla, FB, etc.). Thank goodness Vanguard tells if it’s a growth or value fund…so I can go find a blended fund instead like VTSAX for example. But those index funds contain the same dividend companies that Kyle was arguing it’s OK to buy individually, what’s the harm in that? So, if he/she has bought 25-100 companies, he created his own index what he believes in to work out and get the divvies instead of selling shares when it’s time to use them for retirement. From accounting standpoint, he will not need to track and recalculate his basis each time he sells shares. I sometimes shudder thinking how I’ll have to sell shares from funds in my taxable account. I’m on the auto-invest. It used to be weekly, but now I set it to monthly. Can you imagine how many purchases I’ll have after say 10-20 years of weekly/monthly investments at $100-300? Yeah, DCA’ing is wonderful and I’m a good saver, but I mentally cannot save $100/week in a savings account to be able to invest $5k at the year end (I recall WCI writing that it’s better to invest in lump sums). I’m not a doctor like y’all here, so I cannot invest $2k-5k a pop, but at least I’m saving instead of shopping at a mall. But once I retire I’ll have to go in reverse and sell those tiny lots on quarterly or semi-annual basis. I’m guessing, individual identification will be the best method for tax purposes (have no clue yet how it all works on Schedule D, etc.), but I hope Vanguard will agree to go this route or I’ll be screwed big time. Now in Kyle’s case, he’ll be sent divvies and he’ll have almost no headaches reporting to the IRS.
If you don’t believe in dividend investor you would also push aside Josh Peters of M* views, though M* decided to let him manage a dividend fund based on the companies that he featured in his monthly Dividend Investor. Of course, I do agree with y’all: we don’t know what future holds, everything is in hindsight 20/20.
I agree that making weekly, or even monthly purchases of a mutual fund in taxable creates a tax nightmare, but fortunately much of the nightmare can be automated and uploaded directly into Turbotax or similar.
Dividend stock buyers still have to report capital gains/losses. I mean, a “dividend stock” gives you a 3-4% dividend where a “regular stock” gives you a 2%. Minimal difference in tax issues other than the dividend stocks are slightly less tax efficient.
I worked at Morningstar as a healthcare equity analyst, and I know Josh. He values the stocks in his dividend portfolio in the same way that everyone else at Morningstar values non-dividend payers: DCF model. He simply has a mandate to restrict his picks to dividend payers–because there is a large slice of Morningstar readers interested in dividend payers.
Interesting…my comment I posted in the afternoon today disappeared…as if trying to screen out dividend crazies that TR people dislike. Very curious why my comment vanished. I saw it post but now in the evening I don’t see it. And I’m just “in between” camps so not totally a dividend adoring person, but got deleted. Well, it shows that comments are selectively posted.
Oh well, censorship thrives LOL.
Give me a break. Like I have time to censor stuff just because I don’t agree with it. I only censor stuff that is obvious spam, ad hominem attacks, pornographic etc.
If you’ve never operated a blog before, you probably don’t realize how much spam hits it on a daily basis (perhaps 400 spam comments a day in my case). So you have to set spam filters. Too loose and you get a bunch of spam comments. Too tight and legitimate comments get held for approval. That’s what happened to your other comment. Why some comments get held and others don’t is often a mystery. It looked like spam to the software. Probably the length without any paragraph breaks.
I agree that both sides are cultish and dogmatic. I consider myself now flexible, pragmatic, and probabilistic. There is no magic between the styles of investing that leads one to make less emotional trades, so thats an issue with all types of investing. You’re also absolutely correct that an index or some factor etf (likely too expensive to be justified) is weighted heavy at the top to where it is hardly too much different than a basket of stocks. Except it self adjusts, rebalances, aggregates winners and tosses losers, all the while requiring zero of your attention or involvement. I prefer simplicity more, and dont want to open my account to see tons of stocks I have to keep up with and adjust over time, which you’d have to do since owning the “market” at any one time and just holding without change would have led you to own a smaller and smaller percent of the overall market that grew ever non representative of it as well. If thats the case, then really whats the point?
There are more obvious and structural ways to earn a market premium that dont rely on history repeating itself (outside of general market growth). Its not that dividend investing wont work or doesnt, its that anything works with enough capital, and on a risk adjusted basis, value of your time basis, it just doesnt perform enough with enough conviction for me to care. The reach for yield is real, look at how poorly REITs and Utilities have performed the last couple months with just anticipation of a 25 bps hike (spy 2.73% off highs, VNQ off 9.89%, XLU off 10.3%). The rotation should we actually start in on a hiking schedule will be interesting to see what has been mispriced and for what reasons (post hoc, but still interesting).
Not sure I would call myself an index guy, definitely total return since thats all that really matters. More is more any way you cut it. Indexes just offer the simplest and most friction free way to get what you want while limiting risk. There is no free lunch. Im just much more confident the SP500 will be around in 50 years than any dividend aristocrat.
Great article. Thanks for posting.