There is a large body of personal finance advice that states that investing for dividends is unwise and tax inefficient. The argument is that when a company pays a dividend, the stock price must decline by the amount of the dividend to reflect the declining assets on the balance sheet. Hence receiving dividends is no different to simply selling shares except the difference is that the company makes the decision to sell rather than you. The argument goes that while you are working and earning a relatively high income, it is better to not receive dividends, which will be taxed heavily (because of your high income). It is better instead to let the earning accumulate as capital gains and then realise those gains after you retire when your income (and hence the tax bracket you’re in) drops.
About two or three years ago, I was strongly persuaded by these views (known as the dividend irrelevant theory). In a 2019 post titled My Changing Views, I said the following:
I believed that financial independence depended on dividends alone. If you generate high dividends, you will have enough to live off the dividends and become financially independent quickly. When I read back on my earlier posts (e.g. Dividends vs Capital Gains and 4% SWR vs Living off Dividends), I now notice that I seem quite cultish and stubborn in my views that dividends from Australian equities with franking credits was the only legitimate route to freedom and that anyone who does anything contrary to this is a slave! When I was in my twenties, I would dream of a life in my thirties, forties, and beyond flying around the world, relaxing on beaches, and living off dividends drinking coconut by the beach as I read books. Perhaps I am becoming more mature as I head into my mid-thirties. I have since relaxed my views on a pure Australian dividend focus. Even though I did invest in some foreign equities, I had the bulk of my investments in Australian equities, and one of the consequences of that is that capital gains were not as high. Had I invested in foreign equities, my net worth today would be much higher. Things may change in the future. I will not tinker too much with my portfolio. For all I know, the Australian stock market may perform very well, but what this illustrates is the importance of global diversification. Australia only makes up 2% of global equities, which is almost nothing, and you never know what policies may be implemented within a country that impacts on every single company in that country.
My scepticism of dividend investing and growing belief in the dividend irrelevance theory didn’t start in 2019. I had been thinking about it for a while. When I think about it today, I may have been strongly influenced by FOMO after seeing the performance of Australian equities (high dividends) relative to foreign equities (high growth). As a result, I did divert more money into foreign equities and even cryptocurrency. I also used my margin loan to leverage more into foreign equities.
Indeed, in the past few years, foreign equity and crypto (especially crypto) has outperformed Australian equity. In the past five years, Australian equity as represented by VAS went up 32% whereas foreign equity as represented by IWLD went up 58%. However, the total crypto market cap has gone up 20525% in the last five years.
Returning to living off dividends
Recently I have decided to shift my focus back to dividend investing. I have learned that going into debt and focusing on capital gains has some negative side effect.
I will not be selling my high growth and low yield investments (mostly foreign equity ETFs and crypto), but new money from my salary will now be invested into investments that pay high passive income e.g. Australian equity. (I am also looking into crypto staking as a way to earn passive income, but I am very new to this and that is a topic for another blog post.)
Sometimes it’s worth paying extra for professional service
According to the dividend irrelevance theory, receiving dividends is no different to selling shares except the company sells for you. In other words, the board of a company, a group of professionals, make the decision on how much earning to distribute to shareholders as dividends. Because professionals are making this decision, I like to use the term “professional dividends” as it contrasts with the term “homemade dividends.”
Homemade dividends refer to a form of investment income that investors generate from the sale of a percentage of their equity portfolio. The investor fulfills his cash flow objectives by selling a portion of shares in his portfolio instead of waiting for the traditional dividends. Usually, if a shareholder needs some cash inflow, but it is not yet time for a dividend payout, he can sell part of the shares in his portfolio to generate the required cash inflow.Corporate Finance Institute
In my opinion, there is a benefit to relying on professionals to decide how much to spend and how much to reinvest. The 4% rule is a rule of thumb and is not perfect. It takes historic stock market performance in the US and assumes that what has happened in the past will likely happen in the future, but we don’t know if what has happened in the past can be extrapolated into the future. The high stock market returns of the past may have been fuelled by an abundance of natural resources, high fertility rate, and central bankers continually dropping interest rates. What happens now that natural resources are more scarce and the world faces climate change risk, low fertility rate, and interest rates dropping to near zero?
One of the principles of index investing is that you let the market decide rather than engage in “active investing.” The idea of letting an index weight companies by market capitalisation is that you have a higher exposure to companies that the market deems as better. In my opinion, the same idea applies to dividends. Generating homemade dividends seems like active investing. You are making very bold predictions about the sustainability of your wealth when using rules of thumb such as the 4% rule. By relying on the boards of multiple companies to decide the dividend payout ratio, you are crowd-sourcing what professionals and the market believe is an optimal amount of earnings to distribute as dividends. When boards make this decision, they are considering many factors such as risks they foresee in the future. When COVID-19 hit, many companies decided to reduce dividend payouts based on their judgements. Even if the judgment of these boards are not great, if a company pays out too much in dividends then the market should be able to detect this and reduce the share price, which, assuming you’re investing in a market cap weighted dividend ETF, means that your exposure to these types of companies is reduced.
We rely on professionals for many things in our lives e.g. accountants, lawyers, doctors, and even personal trainers. Often it is better to relying on professionals rather than do it yourself. The same idea applies to dividends.
Investing is emotional
One of the benefits of letting boards and professionals decide how much to distribute as dividends is that it takes out emotion. If you are generating your own homemade dividends by selling down stock, you will likely be overcome with emotions. If you sell too much, you might deplete your wealth before you die. If you sell too little, you will deprive yourself right now, and a stock market correction in the near future may wipe out all those gains anyway.
If you try to take away this emotion by relying on rules of thumb such as the 4% rule then you run the risk of being overly simplistic and extrapolating historical performance into the future. By outsourcing this decision to professionals and the market, you reduce emotion significantly.
When saving money, it is often advised that you should “pay yourself first” or “set and forget.” You should ideally automate everything so that you don’t need to think too much about it. Those who try to time the market tend to mess things up. The same logic applies to homemade dividends vs professional dividends. Living off dividends is automatic. Everything occurs in the background and you only see the dividends hitting your bank account.
A bird in hand is worth two in the bush
Another argument for dividend investing is that we do not know if a catastrophic market crash will hit us in the future. If we live off dividends rather than let those earnings compound on a company’s balance sheet, then certainly the growth of our net worth may be lower, but we spend more today, which can help address feelings of deprivation associated with aggressive frugality. If we focus entirely on capital gains, who is to say that just before we retire or during our retirement, an enormous market crash won’t wipe away everything? At least if we invest in high dividends and spend all our dividends, even if everything collapses near the end, we can look back and be happy that we lived off dividends.