Dividend Dilemma? Fuhgeddaboudit

Mar 7, 2023

Warning: Some simple math is included in this article.

Up until last year, there was no dividend dilemma. Cash in bank deposits and money market funds paid around zero, and dividends on common stocks paid between 2% and 4%, and in some cases more. Slam dunk, dividends were the easy income choice, especially since stock market risk aversion helped blue chip dividend paying stocks perform better than most stocks and indexes in 2022.

Now the game has changed. Due to a series of Federal Reserve short term interest rate increases, most money market funds pay over 4% and a 1 year US T bill pays around 5% . Why accept risk in dividend paying stocks and get only 3%- 4% on average when you can get 5% in a one year T bill with no risk? As we used to say where I grew up in Brooklyn, “Fuhgeddaboudit”.

If you are looking for straight income only, with no desire to grow your investment over time, you have, at least for now, a good income solution. Take the 5% T bill and enjoy your meditation session or your Zumba class or whatever.

But what if you have a real long term investment plan that aims to create not just income but exponential wealth over time? There is a practical way to think about the dividend vs. gains dilemma.

There is this thing called “Total Return”. It’s not a new shiny object like AI, it’s an old strategy. The thing about total return strategy is that unlike a lot of other investing models, total return has a reliable batting average over time. More like Freddie Freeman (Dodgers) than Adam Dunn (White Sox) if you want a current baseball reference.

Total return is simply assembling an annual rate of return by combining income from interest and dividends with incremental gains in a portion of the portfolio invested in dividend stocks. Assume you earn 5% in cash-or T bill returns on half of your portfolio while earning 3% in dividend paying blue chip stocks. In an average year where stocks gain around 7-8%, your total return can equal that same 7-8%, but with only half of the risk of a portfolio invested in stocks.

Example: 50% of portfolio in 3% dividend stocks x 50% =1.5% income return. 50% in a 5% T bill =2.5% return. So far without gains, your return is 4%. Take 50% of an average 7% stock gain =3.5%

1.5 +2.5+3.5 =7.5%. with only 50% at risk. “Risk adjusted” return is 15%.
Average historical stock returns are around 8% risk adjusted.

This can work in negative market environments as well. In 2022 most stocks were down sharply. For example, an investment in AbbVie Pharmaceuticals paid a dividend of around 4% in January 2022 and started the year at around $136 per share. AbbVie gained around 13.9% in price and paid a 4% dividend. A position of 50% in AbbVie and 50% in money market funds or T bills (which averaged only about 2.5% during 2022) would have resulted in a total return of approximately 11.45% while the S&P 500 lost 18.11%, while only taking half of the risk of the S&P 500. AbbVie is not even the best example, Merck, Chevron, Exxon-Mobil and others did even better.

But what if you pick a dividend stock that goes down? Let’s do the math: We’ll use Clorox as an example of a losing trade. Clorox got clobbered in 2022, starting the year at around $178 a share and finishing 2022 at around $149, a loss of 16.3%. Clorox paid around 2.6% in dividends during the year. 50% in money funds or T bills and 50% in Clorox stock resulted in a net loss of 6.9%, much better than Clorox stock by itself or the S&P 500.

In total return, your gains tend to be more frequent and on average significantly larger than losses.

The income on cash or T bills is the key element here. Now that cash earns a strong rate of return, total return strategy gets much easier. At zero interest rates, total return relied much more on rising stock prices.

Using the total return strategy to reduce risk and enhance returns you can gain at least the average stock return of 8%+ per year with only half the risk in the model we used. Which means you can allocate a bit more risk to stocks and take the total return model one step further. If you reinvest dividends, you can buy growth ETFs like the QQQ or the VUG to augment return. Over time these growth ETFs can gain prodigiously, while your cost for these is zero, dividends having picked up the tab for your growth shares.

One last calculation: Think 8% is not much? A simple 8% compounded return over 9 years doubles your investment and triples it in less than 15 years. Your actual gains would be 11.76% for 10 years and 13.3% over 15 years. All with less risk than the overall stock market. As Albert Einstein once said: “Compound interest is the eighth wonder of the world. He who understands it earns it, he (or she) who doesn’t, pays it”.