The hidden dangers of dividend investing

by James Parkyn

While its hard to prove, dividend investing seems to be more popular in Canada than in the U.S. and other countries. Certainly, there’s no shortage of media coverage, websites and mutual funds devoted to dividend-based investing strategies.

The popularity of dividend-focused approaches may reflect, at least in part, the special tax treatment Canadian dividends receive, or a home bias toward shares in Canada’s banks, telecoms, utilities and other blue-chip dividend payers.

Whatever the reason, the fascination of many Canadian investors with dividends betrays a misunderstanding of how equity returns work and exposes portfolios to higher risk.

Returns from equities are composed of capital gains (price increases) and dividends. As explained in this excellent article by our PWL colleague Dan Bortolotti, dividends and price appreciation are two sides of the same coin.

If a company pays a $1 per share in cash dividends from earnings, its shares become less valuable by that $1, in theory. As Dan explains: “This price drop will not be penny for penny, and it may even be washed out by the normal fluctuations in the daily markets. But there is always a trade-off. After all, when a company pays out, say, $10 million in dividends, it must be worth $10 million less.”

Therefore, it should make no difference to you whether your returns come from dividends or from capital appreciation (ignoring taxes and transaction costs).

However, the direct relationship between share price and dividends is clearly a difficult concept for many shareholders to grasp and that can lead to some risky investment bets. First among the risks is a serious loss of diversification to which dividend investors are prone.

A dividend focus excludes a large and growing number of companies that don’t pay dividends, despite earning high profits. One prominent example is Warren Buffett’s Berkshire Hathaway, which has never paid a dividend under his leadership. In fact, nearly half of all U.S. publicly listed companies paid no dividends between 1963 and 2019, according to this article.

The problem is compounded by the sector concentration of higher-yielding dividend paying stocks. This is particularly pronounced in Canada where dividend funds are dominated by a relatively small number financial, telecom, pipeline and energy stocks.

Then, there’s the danger that dividend payouts will be cut or eliminated during recessions. This was the case during both the 2008-09 financial crisis and the pandemic when one in five companies cut their payouts and one in eight eliminated them altogether.

Finally, investors often buy dividend stocks for the income, but this is less tax efficient than selling shares to generate cash.

The first months of 2021 have been kind to dividend investors as the market rotated from growth to value stocks, a group that includes many dividend-payers. The iShares Canadian Select Dividend ETF, the largest such fund in Canada, returned 12.99% in the first quarter, easily outpacing the broad-based iShares Core S&P/TSX Capped Composite Index ETF’s return of 8.11 %.

It was a very different story last year. Dividend boosters often claim these stocks hold up better in downturns, but that certainly wasn’t the case during the pandemic crash and recovery. ETFs focused on Canadian dividend stocks were “blown away” in 2020 by broad-based ETFs that track the S&P/TSX Composite Index. The iShares dividend ETF returned -0.51 versus +5.61 for the S&P/TSX Composite Index ETF.

The evidence is clear that the best way to build wealth over the long run is by diversifying as widely as possible within and across asset classes and geographies. Dividend investing not only fails the diversification test but also exposes your portfolio to the risk of not delivering the income you were counting on.

Certainly, dividends are an important part of overall stock market returns. However, when it comes to dividends, too much of a good thing can be bad for your financial health.

Learning the lessons of the bond market sell-off

by James Parkyn

The stock market is definitely the star of the investing world—it gets most of the attention from the media, analysts and individual investors.

That’s been especially true over the last year, thanks to a roaring bull market that’s sent the S&P TSX Composite Index up over 65% and the S&P 500 by over 75% since the COVID market crash bottomed out on March 23, 2020.

The bond market, by contrast, usually doesn’t attract a lot of mainstream attention even though it’s far larger than the stock market and plays a crucial role in both the economy and in diversified investment portfolios.

However, the bond market has been making headlines of late. Since the beginning of the year, bond prices around the world have fallen sharply and yields have spiked higher. (Yield is the rate of return investors currently earn from interest paid by bonds. Bond prices and yields move inversely.)

After hitting a low of just .45% last summer, the yield on the Government of Canada 10-year bond has more than tripled to around 1.50% currently. It’s been a similar story in the U.S. and other major markets.

The drop in bond prices (and rise in yields) reflects growing optimism about stronger economic growth as vaccination campaigns gather steam and stimulus continues to be pumped into the economy by governments and central banks. Investors are betting faster growth will cause an uptick in inflation, prompting higher interest rates.

It’s a big change from the sentiment that drove bond prices higher last year. Back then, the economy was suffering through a historic recession, central banks were cutting interest rates, and if anything, the concern was about deflation, not inflation. Bond prices rose sharply, sending yields to rock bottom levels.

As a result of those rising prices, the Canadian total bond market generated a generous 8.69% return in 2020. It’s been a very different story so far in 2021. The drop in bond prices wiped out more than half those 2020 gains in just two months.

This points to the relative riskiness of long-term term bonds, which are far more sensitive to interest rate changes than short-term bonds.

With interest rates being so low, many investors have been willing to buy long-term bonds or ones with lower credit quality because they pay higher yields. That’s in keeping with a general willingness these days to buy risky assets of all kinds, from cryptocurrencies to high-flying tech stocks to special purpose acquisition companies.

However, as we’ve seen with the reversal in bonds, capital markets can turn rapidly. It’s something Warren Buffett warned about in reference to low-quality bonds in this year’s letter to Berkshire Hathaway shareholders.

It’s important to remember the role a bond allocation should play in your portfolio. It’s there to cushion against volatility in the stock market and provide liquidity. That’s why we stick to short-term, high-quality bond funds in the portfolios we manage. Their low volatility provides the stabilizing benefits we are looking for through market cycles.

As for the recent drop in bond prices, the good news is that this short-term pain will give way to long-term gain. Bond yields have risen and that means higher expected bond returns over the longer term.

Why worry about whether we’re in another speculative bubble?

by James Parkyn

It’s been almost a year since the World Health Organization declared a global pandemic in response to the spread of COVID-19. As we discussed in our recent portfolio performance review 2020, no one could have predicted the extraordinary events of the past year or the markets reaction to them.

The market crash in February and March 2020 was the worst since 1929 as the gravity of the pandemic crisis became clear. Then, the markets came roaring back with extraordinary speed and ended the year at all-time highs.

It was a year like none other in memory and provided a remarkable lesson on the importance of disciplined asset allocation and the danger of trying to outguess the markets by jumping in and out of investments in hopes of cutting your losses or maximizing your gains.

That’s called market timing and researchers have found it to be one of the worst wealth-destroying mistakes you can make. For example, the Dalbar research firm found that poor trading decisions caused the average U.S. equity fund investor to earn annual returns that were 4.7 percentage points below those from the S&P 500 index in the 20 years to the end of 2015.

People who try to time the market are often driven by a fear of losses or a desire to make big profits, but as we’ve seen in dramatic fashion this year, it’s impossible to forecast where the markets are headed.

The danger becomes clearer when we dig a little deeper into recent market trends. Growth stocks in general—and big tech stocks in particular—produced by far the best results in 2020. In the U.S., large and mid-cap growth stocks returned 36% versus just 1% for value stocks—the largest divergence ever recorded.

Skyrocketing prices have captured the imaginations of many investors who have bought into tech stocks and other hot investments like electric car maker Tesla and cryptocurrency Bitcoin. Meanwhile, others are dumping their stocks because they fear a speculative bubble has inflated of the kind seen during the dot.com era of the late 1990s.

Which side is right? A rational investor doesn’t have to engage with either. The antidote to the stress of worrying about current market conditions is a portfolio that is broadly diversified across asset classes and geographies and a patient, long-term perspective.

We make no judgment about whether U.S. growth stocks are in a bubble, but we do observe that value stocks and markets in other parts of the world are currently trading at far lower valuations. The beauty of diversification is that when one market is falling, others will be performing relatively better.

The real danger in investing is not missing out on a hot sector bet or suffering through a market correction. It’s making poor decisions in the heat of the moment that can lead to a permanent loss of capital.

Our discipline of sticking to diversified asset allocation may not produce the excitement of jumping on the latest zooming tech stock or cryptocurrency, but it has been proven to be the prudent way to build wealth over the long term.

Last year was a high-speed test in managing our emotions

by James Parkyn

In year-end retrospectives over past few weeks, we’ve been reminded just how extraordinary 2020 was on so many fronts.

From the COVID pandemic to the Black Lives Matter movement to the fraught U.S. election and many other momentous events and devastating outcomes, it was a year that challenged our emotional resilience like none other in recent history.

It was no different in the markets. The stock market crash in March gave way to a lightening fast recovery. For investors, 2020 was a real-time, high-speed test of our risk tolerance and how well we’re able to control our emotions in the face of exceptional volatility.

To learn the investment lessons of 2020, it’s instructive to think back to how we all felt at various points during the year. The initial market plunge understandably provoked fear in many, especially because it came at a time of great uncertainty in other areas of our lives, as we navigated a health and economic crisis.

When the markets rallied, many investors were still processing the crash and were distrustful the recovery could be sustained. As it became clear, massive governments and central banks interventions were supporting the economy and markets, investors became increasingly confident in the rally’s durability.

The remarkable market gains since March have once again been concentrated in the technology sector where enthusiasm has been fuelled by the economic effects of the pandemic, including remote work and online shopping. And then there’s Tesla—a phenomenon unto itself.

When fear fades, regret often takes over. How much money could you have made by betting on a few big tech names rather than broadly diversifying your investments?

How about the strength of the U.S. stock market versus developed and emerging markets elsewhere in the world? Wouldn’t it make more sense to concentrate on the U.S. market.

However, if 2020 taught us anything, it’s just how unpredictable the markets can be. Our portfolios must be designed to both weather unexpected developments and take advantage of favourable outcomes.

As investment author Larry Swedroe observed in his review of the book, The Psychology of Money by Morgan Housel, these are not easy psychological waters to navigate.

“Unexpected events and random luck can lead to good decisions having bad outcomes and poor decisions having good outcomes,” Swedroe writes. “Success is a lousy teacher because it can seduce us into thinking we cannot lose. Thus, we should not become overconfident in our judgments when things turn out well. Similarly, failure is a lousy teacher because it can seduce smart people into thinking their decisions were poor, when failure was just the unforgiving reality of risk showing up.”

It’s not easy for bright, successful people to accept their inability to outsmart the markets. However, sticking with a well-engineered portfolio through good times and bad is the hallmark of intelligent investing.

Helping clients manage their emotions is an important part of what we do here at PWL Capital. In that sense, we see our role as advisors helping people make good decisions, not facilitators of risky moves driven by passing emotions.

The coming year will no doubt hold more surprises, but there is much to be hopeful about with the roll-out of vaccines around the world. We will be here to keep your investments and personal finances on track, and the whole PWL team wishes you a happy, healthy and prosperous 2021.

Studying past fund performance won’t get you where you want to go

by James Parkyn

It’s been quite a rollercoaster ride for investors this year. A deep plunge in the stock market last spring was followed by a powerful rally that has sent the S&P 500 to new highs and the S&P/TSX Composite close to its high.

Let’s imagine a retirement saver, named Robert, who has been sitting on the sidelines through all this turbulence and has finally decided to take the plunge and invest a chunk of his money in the stock market.

Robert watches business news channels on TV and has heard various mutual fund managers predict where the markets and individual stocks will be heading in the coming months. With all the conflicting advice and predictions he’s heard, it’s no surprise he has a hard time deciding which managers to trust with his money.

It’s at this point that Robert and his investment advisor decide to look at the past performance of various mutual funds as a guide to finding the best ones to buy.

Of course, they know about the fine print at the bottom of mutual fund marketing materials that warns “past performance is not an indicator of future results,” but how else is Robert supposed to choose?

Sadly for him and countless other investors in actively managed funds, the fine print isn’t just perfunctory boiler plate. Past fund performance actually offers little insight into future returns.

Research by Dimensional Fund Advisors shows that just 21% of top quartile equity funds in the U.S. maintained a top-quartile ranking in the following five years (in data from 2009-2019). For fixed income, the number is 29%.

Even if you were one of the lucky ones who had invested in one of those top-performing funds, you would have had no way of knowing it when you made your investment. The odds were definitely against that outcome.

Indeed, a huge percentage of fund managers don’t generate returns over their benchmark index. In the case of actively managed U.S. equity funds, 89% underperformed the S&P Composite 1500 index over ten years to the end of 2019, according to the S&P Dow Jones SPIVA report.

Even a mutual fund manager who is able to beat the market for 10 years or longer might just be the beneficiary of random luck.

The most famous example of a manager whose luck ran out spectacularly is Bill Miller. Managing Legg Mason’s flagship fund, Miller beat the S&P 500 index for an astonishing 15 consecutive years from 1991 through 2005. Then, as the financial crisis and recession began to unfold, Miller made disastrous bets on financial stocks that led to his fund losing two-thirds of its value by the end of 2008.

Miller himself attributed his winning streak to “maybe 95% luck.” And a former investment strategist at Legg Mason estimated the probability of beating the market in the 15 years ending 2005 was 1 in 2.3 million.

The reality is that relying on past performance to choose investments is like driving your car looking in the rear view mirror. It doesn’t work (unless you’re driving in reverse). The evidence clearly shows that actively managed funds cannot consistently beat the market and studying their past performance will only gives you the illusion they can.

For Robert, the answer is to stop worrying about finding the best active managers and, instead, use passively managed index funds to build a broadly diversified, low-cost portfolio. That’s the way to keep your eyes on the road ahead and be prepared for any turns, bumps or detours that may come along the way.