Recently, I received a question from a prospective investor: Should you borrow to invest in dividend-paying stocks? As a professional with a clear bias for dividend-paying stocks, I’m always happy when someone shares my investment approach. But sometimes investors can get carried away.
Should You Borrow to Invest in Dividend-Paying Stocks?
With a seemingly never-ending climb of stock market indices breaking new highs (up until last week), it was inevitable that folks would ask this sort of question. I mean, if you can take out a loan for $50,000 and buy a portfolio of dividend-paying stocks or Exchange Traded Funds (ETFs) that pay out a healthy 4% dividend, why not? And if you can buy a stock or ETF that pays out 4% monthly versus quarterly or annually, well, that sounds better so how can you lose?
Well, the problem comes down to understanding some basic math and physics. In the case of the latter, the laws of gravity still apply to stock markets in the near term: what goes up has a tendency to come back down. This is sometimes referred to as a “reversion to the mean” but means that over time everything tends to average out.
For the former, well, let’s say this investor was being a little too hopeful.
The Compelling Story of Dividend-Paying Stocks
Dividend-paying stocks are a great part of any investment allocation. Stock returns are comprised of two parts typically: capital appreciation (buying low and selling high) and dividends (a payout to stock owners).
Research has shown that stocks that pay dividends tend to perform better than those that don’t pay dividends. Other research has also shown that stocks paying a dividend that increases consistently over time do better than even those dividend stocks that pay out a static (or unchanging) dividend.
Dividends are a return of a portion of profits to a company’s shareholders. They have proven to be an important component of total return. By some measures they have comprised about 40% of total US stock market returns since 1930. Stocks of companies that pay growing dividends (dividends that increase year-over-year) have exhibited less overall volatility than other non-dividend-paying stocks.
Added to the benefit of consistent income, these types of stocks can also provide a hedge against inflation which is one of the biggest risks for a retiree.
For a broad review of research in support of the role of dividend-paying stocks in any portfolio (not just retirees), you may want to check out “Why Invest in Dividend Stocks?” published in 2012. The solid reasoning hasn’t changed since this review first appeared.
Because of these reasons, I typically include a healthy allocation to dividend-paying stocks (US and International) in the MarketFlex Portfolios that I manage for clients.
Dividend Aristocrats and Dividend Kings
For the do-it-yourself investor, there are great services out there that may help you select high-quality dividend-paying stocks. Generally, I prefer to select from a list of stocks that have consistently paid out an increasing dividend for a minimum of twenty years.
These are referred to as “Dividend Aristocrats.” An even more exclusive list are those companies which have paid out an increasing dividend for at least fifty years. These are referred to as “Dividend Kings.”
Either of these approaches may be accessed through mutual funds or even ETFs if you don’t want to bother with individual stock selection like I do.
Setting the Record Straight
While I applaud any investor for being open to adding dividend-paying stocks to any portfolio, I do need to set the record straight. Sometimes an investor may hear the term “monthly” or “quarterly” dividend and get a bit confused like my prospect here.
As much as it sounds great to find a stock paying a 4% monthly dividend, the reality is different. Unfortunately, in this case, the investor was confused about how monthly dividend stocks may work. While the dividend yield may be 4%, that is an annualized rate. You as an investor will be receiving a payout of the dividend each month. So, you’ll only be receiving one-twelfth of the annual yield each month not receiving 4% each month.
For example, you might be tempted to borrow $50,000 at a rate of 3% per year and invest all of it in a selection of monthly dividend-paying stocks or ETFs paying a yield of 4%. In reality, this strategy would likely yield $2,000 per year or $167 per month.
Monthly pay-outs unfortunately don’t mean that the 4% rate is paid out each month. Instead, it is paid out in increments over time. Monthly pay-out dividend stocks are more attractive to investors so that the cash inflow can match cash outflow needs. But in order to generate $2,000 per month in dividends, you’d need to have a portfolio of about $600,000 which is far less than what this prospective investor had available.
And while a dividend oriented portfolio tends to exhibit lower volatility (i.e. risk) over time, it will still be riskier than holding cash to cover your day-to-day or month-to-month fixed overhead expenses. So, a retiree would likely need to have a total portfolio that was more than $600,000 when including projected cash reserve needs.
For a personalized review of your retirement portfolio needs, reach out to Steve Stanganelli at Clear View Wealth Advisors, LLC.
