Podcast Ep. 140 What Most Investors Get Wrong About Dividend Investing

[00:00:00] Hey everybody. Welcome back to The Optometry Money Podcast. We’re helping ODs all over the country make better and better decisions around their money, their careers, and their practices. I am your host, Evon Mendrin, Certified Financial Planner(TM) practitioner. And owner of Optometry Wealth Advisors, an independent financial planning firm just for optometrists nationwide.

Evon: And thank you so much for listening. I really appreciate your time and your attention. And onto today’s episode, we are gonna dive into dividend investing. we’re gonna dive into trying to demystify dividend investing and tackle some of the, what I think are myths or misconceptions around dividend investing and there are a lot of approaches to investing out there. Few of them attract so many extremely dedicated followers, quite like dividend investing. You don’t have to search the internet and social media for very long to find bloggers and profiles and, [00:01:00] and, content creators that have dedicated their, literally their whole identity.

To dividend investing or income investing in general. This sort of this broad overarching theme of, of income investing, investing only for and for the sole purpose of the cashflow, the income that’s generated. also see opinions around retirement planning that when planning for retirement you need to have X amount of dividends from your investments in order to retire before that you’re not quite ready.

And there are a lot of opinions out there that can easily impact your thinking and planning around retirement and sometimes the stress around retirement. And as I look at these comments and opinions and arguments around dividend investing, there tends to be a misunderstanding of what dividends are.

How they work and how they impact the price of these businesses. So today I’m gonna dive into how dividends work. We’re gonna tackle some myths and misconceptions, and ultimately [00:02:00] talk about why dividend strategies may not be the holy grail they are made out to be. So with that in mind, let’s dive in.

What Are Dividends, and How Do They Work?

Evon: So to start, let’s talk about what are dividends? How do they work? a dividend is a cash payment. It’s a distribution of cash made by a company to shareholders, usually from profits. So companies are distributing out profits to the owners and companies like publicly traded stocks, pay dividends, often, quarterly or annually as a way to return capital to shareholders.

Think about an Optometry practice. If you own an Optometry practice as the owner of the practice. An important role that you have is making decisions around cash flow as revenues coming in, as cost of goods and operating expenses are, are tackled, and you have additional cash flow left over after making debt payments.

What do you do with that additional cash? , These are really important functions of the owners, is, is making [00:03:00] decisions around what to do with cash flow. And in your practice there’s really only four decisions to make.

There’s investing, number one, investing back into the operations of your practice. So new equipment and technology, building out new lanes, hiring, marketing. Better frame board management or inventory management, et cetera. So number one, investing back into the current operations of the practice.

Number two, expanding by buying other practices or cold starting new locations. number three, paying down debt.

Or number four, distributing cash out to you, the owner, which that, that distribution is the equivalent of a dividend in a corporation. And depending on the needs and goals of your practice and the personal finance goals of you and your family, you’re gonna spend some time each year deciding how to use the precious cash flow your practice generates.

This is what are the most common questions that I help practice owners solve is figuring out, okay, what, what cash flow is really available in the [00:04:00] practice, and what should we do with it?

Well, the CEO of a public corporation is doing the same thing just on a much larger scale. So one of the most important jobs of A CEO is deciding how to put cash to use and a CEO can make the same exact decisions, with one additional one.

So they’re going to invest in their operations. They’re going to acquire other businesses, they’re gonna pay down debt, they’re gonna pay a dividend to shareholders. Or they’re going to repurchase stock. Stock buybacks.

The first of those two – Investing in operations, Acquiring other businesses – are ways to use cash flow to reinvest internally and improve the value of the shares, increase the value of the shares over time.

The last three ways are ways to distribute value back to shareholders. Back to owners paying down debt. You’re probably wondering how does that. Bring value back to shareholders. Well, when you pay down debt, [00:05:00] you are increasing owner’s equity. so you’re increasing the equity of shareholders. That’s the claim that you as the owner have on the assets and the cash in the business.

And so, and the same thing happens on your practice as balance sheet. When you decide to pay down debt in the practice, your owner’s equity is increasing. dividends give cash directly back to shareholders, back to owners, and stock buybacks. Give cash directly back to owners that want to sell. And for ongoing shareholders, there are less shares outstanding.

And with a similar market valuation, your price per share is increasing. It’s effectively mathematically the same outcome as the dividend. some think of share buybacks as, as net share buybacks as a sort of. More tax efficient dividend or a flexible dividend.

Why Do Companies Pay Dividends?

Evon: And why do companies pay dividends and distribute cash to shareholders?

Well, again, think about your own practice. When deciding whether to distribute cash to yourself, you’re probably thinking through, okay, [00:06:00] are there investment opportunities in the business that are going to generate a strong, reasonable rate of return? If not, you’re thinking about whether you should be paying down debt and making sure you’re setting, setting aside enough for, for quarterly tax payments, there’s a reasonable cash buffer and if all of those things are met, then you can distribute cash to yourself and use it more effectively outside of the business, reinvesting into investment accounts and retirement accounts, or real estate or whatever it may be.

There’s only so much equipment you can buy and you may be working with a certain amount of square feet, where at some point buying stuff in the business. just doesn’t provide the best return on the asset.

And in the same way, corporations may not feel when they’re looking at their own business, they may not feel there’s reinvestment opportunities in the business that can provide value above and beyond what maybe the general stock market may provide.

maybe they have such strong cash flow that they just don’t have enough reinvestment opportunities in the business. And [00:07:00] so they distribute profit to owners so the owners can make their own investment decisions. and on the other hand of that, there’s corporations that may feel like they can make better use of that cash internally, and so they’ll retain the cash and they will not pay out dividends.

Berkshire Hathaway is a really great example of this. It’s a long standing historical company, and as Warren Buffet is written about they believe they can invest the cash more effectively than shareholders, and so they retain it and reinvest it internally.

it may also be a signal to investors about future profitability.

So they may be doing this as an incentive, as a signal for investors so they would buy their stock. So maybe there’s a behavioral part of that too, a signal. not all companies pay dividends. It’s, as I mentioned earlier, globally, when you look at, when you look at the global stock market. Combined, roughly half of stocks pay dividends last, last data I saw and roughly half does not.

And over the decades, the number of [00:08:00] corporations paying dividends has declined as well as the percentage of their earnings that are being paid out. especially in the US since the mid eighties or so, as stock buybacks were made Much easier from a regulatory perspective.

And just like your practice, , your practice generates cash flow for you to use. But it’s also an asset on your balance sheet. It has a value. And returns from owning a publicly traded stock any business come in two forms. It’s capital gain, which is the increase in the price over time and distribution of cash to the shareholders, often in the form of dividends.

And so dividends are a part of a component of total return. an important part, Mel Faber in his book, Shareholder Yield writes that when looking at the US stock market from 1871 to 2023, US stocks would’ve realized a 9.16% compound annual return, average annual [00:09:00] return. When you exclude the dividends – so you don’t reinvest the dividends back into the market, and you only look at the price change of the, of the, of the US stock market – if you exclude dividends, it would’ve reduced the annual compound return to 4.67%, roughly cutting that in half.

Importantly, it’s not the dividends themselves. Capital gains tend to provide most of the return on just like a year to year basis. If you look at the components of return, it’s the, it’s really the fact that you’re taking those dividends and reinvesting them back into the market, buying more shares, and those shares then increase in price over time, and those shares also distribute dividends, and you just keep that cycle going.

It’s really an example of compounding growth. If you don’t re and if you don’t reinvest the dividends, if you just take the dividends, dividends as cash and let ’em sit as cash, or if you take it for spending, you’ve historically, severely impacted your returns over time relative to the broad market. [00:10:00] And importantly, if, and this is hard to wrap your brain around, but if, if the companies did not pay dividends The entire return would just be reflected in the price change over time.

We would not expect the lack of dividend to impact the return that you get as an investor. The dividend may, the dividend just changes the way that return shows up as those corporations would instead reinvest those dollars back in the back in the business.

So dividends themselves don’t necessarily determine the overall return of owning the business. It’s ultimately the earnings and cash flow that drive the return over time and how that cash flow is used.

Timing of Dividend Payment

Evon: And in terms of the timing of dividends, so a corporate board is going to, announce the dividend. this may be paid out quarterly, for example, and then there’s going to be a dividend date. This is the dates that the actual dividend is paid out to those that are on record.

but before that dividend date, just before that is something called the ex-dividend date, and that is the date that [00:11:00] the stock trades without a right to the dividend, meaning if you buy the stock on that day, you would not actually get the dividend. You don’t have a right to that dividend, or you would’ve only gotten it if you purchased it the day before.

So there’s sort of this order this, so there’s this schedule of how these things work out. And it’s the same thing actually with mutual funds and ETFs. If you look at mutual funds and ETFs that you have, those mutual funds and ETFs are going to have an ex-dividend date, the date that they trade without the dividend, and they’re going to have a dividend date, which is the date the actual dividends paid out.

Misconception #1 – Dividends Are “Free Money” and “Extra Return”

Evon: And the first sort of misconception I want to talk about here is that dividends are often thought of as free money or extra return from stocks. There’s sort of a celebration sometimes when dividends hit that brokerage account.

But this way of thinking is a, is a fundamental misunderstanding of how dividends work.

Evon: because when a dividend, when a company pays out a dividend. Its stock [00:12:00] price drops by that amount on the ex-dividend date, meaning that date, that when you buy it, you no longer have a right to the dividend. You’re not gonna be receiving it. The stock price adjusts downward to account for that dividend.

So, as an example, let’s say you owned one share of stock that’s worth a hundred dollars. Your total Wealth here is a hundred dollars, right? It’s just, it’s all in stock. If the stock that you own is going to pay a dividend of $10 on the X dividend date, your stock price will drop by that $10 amount and it’ll be worth $90.

So what you have in your brokerage account is $90 worth of stock and $10 of cash from the dividend. And when you add those two together. It’s a hundred dollars. You have the same amount of overall Wealth. You’ve just changed the composition of it from all stock to, to mostly stock and some cash. And if you’re in a taxable brokerage account, [00:13:00] this is important because those dividends are taxable income and you’re potentially left with a lower amount of Wealth after that tax is accounted for.

That’s theoretically what we would expect to happen, and this is what we see empirically. So this isn’t just theoretical. This is what we see empirically that happens on ex-dividend dates, that the stock price declines by the amount of the dividend.

It’s not always one for one, there’s some academic work showing that prices may adjust less than the dividend amount to account for the fact that taxes actually leaves you with less dollars from the dividend.

But this is what we would expect, and this is what we clearly see empirically. This is a mathematical reality that when stocks are paying a dividend on that ex-dividend date where they trade without a right to that dividend, the prices go down to reflect the economic reality of that dividend.

As an example of this without ha having to dive into any thick academic work here. Dimensional Fund [00:14:00] Advisors, I’ll, I’ll link to this in the show notes, but Dimensional Fund Advisors looked at the 10 largest companies in the S&P 500 High Dividend Index.

So 10 of the largest, highest dividend paying companies in the United States. And from, from roughly a five year period, from, from December, 2018 through October, 2023, there was an average dividend per share of $1, and there was an average share price decline of $1 and 15 cents on that ex-dividend date.

So that’s, that’s a relatively short term example of what we’re talking about here. You may not see this if you looked at, if you have individual stocks in your account, and if you looked at one of ’em, well, you may not see this exactly as clearly as that. We’re laying it out because at any moment in time, really there’s an unknowable amount of factors impacting that stock price on, on a day-to-day, minute to minute basis. But when you look across, when you look across these dividend events, this is what you would see [00:15:00] empirically.

And it’s often said that dividends are safer during stock declines, because when declines are happening, you still get the dividend income, but. As we just talked about, those dividends also negatively impact that stock price. So it’s, it’s sort of a double whammy there on the stock price.

And why is that? Why, why does this decline happen? Well, it’s because that value, all of that cash is being removed from the company, and sent to shareholders. Just from a market perspective, you’re, if you’re buying shares of that company on that day and you don’t have a right to that dividend, you wouldn’t expect to buy the company for the same price, you would expect a discount to account for that.

And from a a, from a valuation perspective, those dollars are no longer on the balance sheet. It’s not a part of equity, and those dollars are not going to be reinvested back into the business to potentially increase the share price over time and Earn a return on equity for owners.

And so prices adjust to reflect that. So dividends are not a bonus. It’s not [00:16:00] free money, it’s not additional income on top of what you’re usually getting. They’re a slice of the pie that you already own. It’s just rearranging your Wealth from shares of stock to cash, and then you have to decide what to do with those dividends.

If you want the overall returns of the market, you have to make sure that you are reinvesting the dividends. And incurring trading costs and potentially taxes in a non-retirement account along the way. And in extremes, if a lot of people are diving into dividend stocks or dividend funds, that can very well push up the stock price.

Likely lowering the expected returns in the future. So in extremes that can actually negatively impact the returns you’re gonna be getting on those stocks, even if the dividend yield is high.

And lastly, on this point, it’s possible that very high yield dividend stocks are signs of distress where the stock price has [00:17:00] declined due to actual I issues in the business or in the industry.

But the leadership are hesitant to cut the dividend due to signaling to investors that there are in fact issues with cash flow. And so high dividend yield does not necessarily mean that this is a, a healthy, robust, high profitable company.

Misconception #2: Tax Implications of Dividends In Taxable Investment Accounts

Evon: The next point I wanna talk about is that there are tax implications for dividends.

As I just mentioned before, when you are focusing on dividend investing and you are trying to target companies or funds. With really high dividend yields when you’re doing this in a taxable investment account. So not a retirement account, not a 401k, not an IRA, but in a taxable investment account.

Those dividend dollars are taxable income in that year, and if they’re, and they can be taxed at, and depending on the type of dividend, if they’re considered qualified dividends. they’ll be taxed at qualified or capital gains tax rates, so 0%, 15%, 20%, with [00:18:00] potentially up to 23.8%, or they may be taxed if they’re non-qualified dividends at ordinary tax rates.

So, so the same tax rates as the rest of your income, 10, 12, 22, 24%, 32, and so on.

And the state taxes may vary the state tax. from a state tax perspective, your state may tax it just like any other income that you’re earning. And so by focusing on income, you are forcing more income onto your tax return, and that tax drag on your returns is a real expense to the returns over time.

When you contrast that to buybacks, for example, buybacks, if you continue to hold the stock. That gives you more control. It allows you to choose when you want to sell that company and incur that capital gain cost. So, so for, again, for optometrists and often relatively high tax brackets, that tax drag can be meaningful, and can leave you with less Wealth than you started out with before that dividend.

This is something when I’m reviewing a, a tax return for a new client, this is one of the things I’m looking [00:19:00] at is how much dividend yield, how much dividend income is getting kicked off onto that optometrists tax return, and is that reasonable?

Are there ways where we can rearrange the, the investments into different accounts in order to improve that tax efficiency? that tax efficiency is really important.

Misconception #3: Dividend Investing Can Lead to Lower Diversification

Evon: One other misconception about dividend investing is that it can potentially lower the diversification your investment accounts.

As we talked about when looking globally, roughly 50% of stocks do not pay dividends, and especially again, since the eighties in the United States. More and more companies have a, have been adopting stock buyback policies as a more flexible way to distribute value back to owners and can very well be much more tax efficient to you, the shareholder. And so less and less companies are using dividends as a way to distribute dollars back to the back to shareholders.

If you’refocusing on high dividend yield funds, you may very well be lowering your diversification. which is a foundational way of managing risk and [00:20:00] making sure that you are opening yourself up to the full opportunity set available to you not only in the United States, but globally.

In addition to that, this focus on dividends and income investing is often an excuse for investors to go to try their hand at individual stock picking and it’s just statistically so unlikely that you are going to be successful consistently picking individual companies that are going to do better than the market as a whole.

I’ve done episodes on this already. Listen to my episodes about index investing. And factor-based investing. But for some reasons, I, I’ve been in conversations where I explain to them the research around how unlikely it is that.

We as individual investors or professional fund managers are going to be successful consistently picking individual stocks and timing markets and outperforming the broad category, broad market as a whole. And they’ll listen to that and say, you know what?

I agree, but they’re not gonna fall in that trap because they’re investing in [00:21:00] quote unquote, high quality dividend paying stocks. And for some reason, the fact that they’re going after dividends is this, excuse where it’s okay to dip your toe into individual stock picking.

I would be very cautious about that. Look at the research available and evaluate carefully whether that makes sense for you.

Misconception #4: Outperformance of Dividend Funds Aren’t Because of the Dividends

Evon: The next misconception I wanna talk about around dividend investing is, that there is potentially outperformance for high yield dividend funds relative to the stock market as a whole.

When we look at high dividend funds or portfolios, there is some evidence of outperformance over the market as a whole. So isn’t that proof then that dividends are this key to investing? Shouldn’t we then pursue dividends? Well, not necessarily.

The return of high dividend stocks are statistically explained primarily by their value and profitability characteristics or the [00:22:00] value and profitability factors.

These stocks tend to be mature, slower growing companies with strong earnings. There is a high amount of overlap between dividend stocks and value stocks, sort of value stocks in disguise,

And it’s the fact that they have value characteristics and profitability characteristics that explains this excess return above the market as a whole. And this is not something new. This is something that’s been observed as far back as 1992 in Eugene Fama and Kenneth French’s research.

I can add a link to that in the show notes too. And I’ll also link to a video by my Canadian peer, Ben Felix, on this topic where he looks at this relationship with live fund data and more recent data, so I’ll, I’ll put a link to that in the show notes too.

The fact is when we look at high dividend funds or portfolios, the outperformance that you might see is explained almost entirely by these stocks, exposure to value and profitability factors or [00:23:00] characteristics. Once you account for those, the dividends themselves do not explain or predict outperformance.

they are not in and of themselves in investment characteristics that we should be tilting forward. I did an episode on this, a little bit back episode 135 An Optometrists Guide to Factor based Investing, talking about the fact that there is clear research showing that there are certain factors or characteristics that have been shown to provide a higher expected return relative to their counterparts. We would expect this to happen theoretically. This is robustly shown throughout historical data. So this is, we see this empirically across time, across geography.

So there are certain characteristics that if you’re trying to improve the long-term outcomes of your portfolio, it may make sense to tilt towards those certain characteristics. But dividends are not one of those characteristics.

So I’ll say again as sort of a conclusion here. If we want to tilt towards robust, [00:24:00] well-documented characteristics that we expect to provide a higher expected return versus the market over long periods of time, then we should tilt towards these characteristics themselves.

Namely value and profitability and smaller companies rather than something that mimics them. Just get the real thing. If you want the thing, just go for the real thing.

Misconception #5: You Need Dividends to Retire

Evon: And then the last sort of set of myths and misconceptions is around retirement planning and retirement income.

And there are many investors that say, I just want to live off dividends or to a further extreme, I need X dollars of dividends before I can retire. And I think there’s a lot of fear around this. I think there’s sort of fear of. Of, of having to sell shares of things during retirement, as if that’s going to destroy retirement feasibility.

I think there’s this sort of fear that drives this way of thinking, but when you look through research around retirement planning and how we [00:25:00] practitioners actually do this for clients in practice. That’s not the case.

You do not need X amount of dividends to cover your full amounts spending in in retirement.

Think about what you own In these investment accounts, you own liquid assets. You can sell shares whenever you want and create your own paycheck.

You own things that can vary easily and quickly and reliably be turned into cash in an instant, in the snap of a finger at prices that are reliable. You can create your own paycheck. You can create your own dividend simply by selling shares.

A certain dividend yield is not necessary for successful retirement and at times can lead you down a road where you feel like you actually need to have a much higher nest egg than is actually necessary.

Where instead we can focus on total return and

capital gains are such a large part of those returns on a year to year basis. It just [00:26:00] makes no sense to ignore such a large part of the return you’re getting in your accounts. What we’re planning around isn’t dividend or interest or income yield, but withdrawal rates.

How much of your total assets are you withdrawing in any given year and and how does that change over time? That’s our focus, and very often it’s not static throughout your entire lifetime, maybe higher earlier in retirements and lower later on in retirement as social security starts and spending decreases.

But it’s those changes in withdrawal rates that we really wanna keep an eye on. And when we’re dealing with taxable investment accounts, this is gonna allow for better tax management and better tax planning without forcing that dividend income onto their tax return.

And it also just doesn’t make sense for the policy of some, disconnected group of corporate boards To dictate your spending in retirement, especially when dividend income can be inconsistent and can actually be cut. And lastly, on this [00:27:00] point, there is this thought that selling shares to create cash for spending is some form of market timing.

Where you’re constantly looking at the ups and downs in the market and deciding whether or when to sell, like that’s dictating to you when you can sell to create cash. But I think this is simply a fundamental misunderstanding of how we handle spending in withdrawals in retirement. There is no market timing involved.

And, and again, I think a lot of that is due to some fear or uncertainty around the action of selling stuff in your investment accounts as markets are going up and down.

Total Return – A Better Way To Think About Investment Returns

Evon: And so when thinking about how dividends actually work and some of these sort of misconceptions or really misunderstanding around.

The impact that dividends have on the, on prices of stocks and overall returns. The, from a purely financial standpoint, I think the optim optimal way to look at investing is total return, which is dividends [00:28:00] plus capital gains. We as investors should be indifferent where our returns come from, whether it’s from appreciation of the stock price, whether it’s from the dividend return, whether it’s from whatever it is we should be indifferent to that and whatever way corporate leadership, the CEO and the board.

Whatever way they wanna handle the cash flow of the business. Let them make that decision in the best interest of the corporation and for shareholders. Let them make that decision whether they see opportunities to reinvest back into the business.

That’s great. If they don’t see those opportunities and what you distribute cash as dividends. That’s great. If they feel it’s a better value due to the stock price and because it’s more tax efficient to shareholders instead to do stock buybacks, even better.

Let them make decisions in the best interest of shareholders. And I will take returns in whatever way, shape, and form that it comes. And if we’re going to be skewing or tilting towards certain [00:29:00] characteristics, in order to improve the long-term outcomes or portfolios, I’m gonna do that as I talked about in that podcast episode based on clearly documented c haracteristics like smaller companies and value companies and more profitable companies. Not because of dividends.

I think this way of investing provides more control over taxation, I think this improves the diversification of our portfolios and overall just the way we design our portfolios.

And, and we shouldn’t let dividend policies of a corporate board dictate how much you spend in retirement. A dividend is not a plan. So let’s put a plan together to make sure that your, that your investment approach aligns with the goals that you’re investing towards.

Behavioral Benefits to Dividend Investing

Evon: That’ll being said. I’m going to sort of contradict myself and talk about why dividend investing can make sense.

And this comes down to behavior. If in underline, in bold, if, if you know yourself as an investor [00:30:00] and you know that just due to your own behavior, your psychology. Dividend investing is the only form of investing that’s going to keep you invested over time and allow you to retire, and you understand the trade-offs that we talked about earlier.

Then dividend investing can be a rational approach for you. As I often say, the right investment approach for someone is one that we believe will work long term. There’s, there’s evidence to suggest that it will be successful long term.

I. And it’s one we can stick with. If dividend investing is the only thing that’s gonna keep you invested and keep you from making bad investment decisions at the wrong time and it’s gonna allow you to feel, to feel like you can retire and going to retire without a substantial amount of stress, well, maybe that approach makes sense for you.

So from a financial standpoint, it’s not optimal. I wouldn’t suggest that as the optimal way to invest. But [00:31:00] behaviorally, if that’s what is going to keep you invested and give you a successful retirement, and you are broadly invested enough, meaning you’re not trying to pick individual stocks, it, then it can make sense.

As a Planner, as someone who works with real people on a day-to-day basis making all these financial investment decisions. I understand that. I think that can be a rational choice for you. But, but do so understanding those trade offs.

Conclusions

Evon: So with that said, hopefully this is helpful for you as you hear all these sort of opinions online, especially about income investing and dividend investing and how everyone needs dividends. hopefully this helps you to understand some of the misconceptions and misunderstandings around that. If you have any questions, please reach out to me, at evon@optometrywealth.com.

If you want to review your own investment approach and make sure that it’s working for you based on the goals that you’re investing for, please reach out. We’d love to have a short introductory call with you, hear what’s on your mind financially and talk about how we help optometrists navigate those same decisions all [00:32:00] over the country.

And you can also follow along as I write about this stuff and more on a week to week basis in my Eyes On The Money newsletter, I’ll throw a link in the show notes so you can sign up for that and when you do that, you’ll also get a copy of 2025’s most important financial and tax numbers you need to know.

So with that, appreciate your time and we will catch you on the next episode. In the meantime, take care.