This week, in the interest of providing some balance, I'll address some of the biggest misconceptions people have about dividend growth investing. Knowing these myths – and why they're wrong – will serve you well in the long run.
It saves you from market meltdowns
No, it doesn't. Several years ago, I remember feeling quite pleased with my portfolio of dividend-growing banks, utilities, pipelines and consumer staples stocks. The prices had been on a steady incline, and so had the dividends. Then, the 2008 financial crisis hit, and my smugness quickly turned to terror as my portfolio plunged in value. Watching my kids' registered education savings plans sink was especially difficult, because I felt responsible for losing their money. The stocks have since recovered, but I haven't forgotten the lesson: Even a portfolio of high-quality dividend stocks will get hammered in a market rout, so be prepared (more on this below).
Wrong again. Once you've assembled a portfolio of dividend-growing stocks, your work isn't over. You still need to monitor your holdings, and take appropriate action if something goes wrong. To take two prominent Canadian examples, Manulife Financial and Yellow Media both had exemplary records of dividend growth before they ran into trouble. Manulife was pummelled by the financial crisis and low interest rates, and cut its dividend in half. Yellow Media was burdened by excessive debt as it struggled to make the transition to an online business, and chopped its dividend several times before eliminating it. It may be easy to say this in hindsight, but investors who got out when these companies first took an axe to their dividends saved themselves a lot of misery, because both stocks are well below where they were at the time.
It always generates the highest returns
True, studies have shown that, over long periods, stocks with growing dividends outperform those with stable dividends or no dividends at all. But that's of little consolation to investors who missed out on the spectacular returns of non-dividend stocks, such as Apple (up 554 per cent over the past five years) or Lululemon Athletica (up 381 per cent since it went public in 2007). The fact is that young, fast-growing companies often find it more advantageous to reinvest cash flow in the business, and investors who insist on dividends will miss out on these multi-baggers. Some of these companies eventually will pay a dividend (Apple, for example), but others will flame out long before that happens (Research in Motion), so you needn't feel too badly.
It eliminates the need for fixed income
Repeat after me: Dividend stocks are not bonds or guaranteed investment certificates. Although fixed-income yields are puny right now, if the market goes for another belly flop – don't kid yourself, it will happen again – you'll be glad to have some bonds or GICs in your portfolio. For example, if you maintain a 60-40 balance of stocks and GICs and the market plunges 30 per cent, your portfolio will be down just 18 per cent. Of course, your gains when the market is rising will be smaller, but that's the price you pay for stability and peace of mind. Your own asset mix will depend on your age, risk tolerance and other factors.
It eliminates the need for diversification
Because Canadian dividend stocks tend to be concentrated in sectors such as financials, pipelines, utilities and telecoms, it's easy to let one or more of these industries make up a huge component of your portfolio. But dividend investors need to diversify like everyone else. One way to achieve this is with exchange-traded funds that invest broadly in dividend stocks from various industries. Another is to invest in U.S. companies in sectors such as consumer staples, consumer discretionary, health care and technology, which are under-represented in Canada.
Dividend growth investing is a great strategy, but it has its limitations. Knowing them will make you a better investor.