investing

This Will Make You Rethink Your Dividend Investing Strategy

Despite the popularity of using dividend yields to choose stocks for their retirement portfolios, there's a better indicator that investors should be looking at.

In the current interest rate environment, individual investors are understandably on the hunt for income. Naturally, many of them turn to dividend investing to generate a steady stream of income, especially in retirement.

However, the problem is that the way most people approach dividend investing is to fall into the yield trap. A stock that pays an above-average yield seems attractive and presumably solves the income problem. But does it?

Focusing on stocks that pay the highest current dividend yield is akin to telling a teenager to drop out of school to work flipping burgers so they can earn an income at that point in time. Wouldn’t they be better off INVESTING in their FUTURE so their income has the greatest potential to grow?

The fact is that dividend-paying companies produce three, not two forms of return: stock price appreciation, current dividend yield, and something else far more valuable but often overlooked: the possibility of future dividend growth.

Current yields are tempting and could produce income streams in the short-term, but it’s not sustainable.

This is not an opinion, but rather a proven fact. To wit, my colleagues and I at Reality Shares looked at Bloomberg data, between 1992 and 2016 and found, on average, the companies with the highest dividend yields historically underperformed the broad equity market on a total return basis. Conversely, companies with the lowest dividend yields historically outperformed the broad equity market.

Getty Images

Certainly, this data is not meant to discourage you from dividend investing, but rather, it should make you rethink your dividend investing strategy. As the following chart shows, nearly 40% of the total return of the S&P 500 can be attributed to reinvested dividends and the power of compounding.

Getty Images

This is not just a domestic phenomenon. MSCI research found dividends were the largest contributor to global equity returns, accounting for 93% of total return over the 20-year period from December 1994 through September 2015.

Getty Images

Dec. 1994 through Sep. 2015. Source: MSCI. Past performance does not guarantee future results.

If you break it down further, dividend yield accounted for only 29% of total return, whereas the growth of dividends represented nearly 65% of the performance over 20 years.

Grocery delivery image

Getty Images

Go for the Dividend Growth

While the allure of a high-yielding stock can be attractive, investors need to remain disciplined and should instead focus on the stocks that are committed to growing dividends. Not only has the dividend growth component contributed significantly to historical total returns, but further research from Ned Davis confirms dividend growers and initiators have historically outperformed all other categories of stocks (over a span of 40+ years).

Growth Funds

Getty Images

So, what is going on here? Remember what Albert Einstein said about the power of compounding: “Compound interest is the eighth wonder of the world. He who understands it earns it . . . he who doesn't . . . pays it. Compound interest is the most powerful force in the universe.” This is the key to unlocking the magic.

But here’s what even the most ardent dividend growth investors get wrong ...

In This Case, Size Really Does Matter

The magnitude of dividend growth actually matters even more so than whether or not a stock grows its dividend. Even among all the brilliant dividend-focused investors, most people miss this. Instead of simply being satisfied with companies that grow dividends, investors should be asking how much they grow dividends.

Companies that grew their dividends the most historically outperformed the broad equity market, and those companies with little to no dividend growth actually underperformed the broad equity market (on a total return basis). The following chart illustrates how the stocks with the highest dividend growth rates have historically outperformed the S&P 500 by nearly 9%, and it emphasizes the relevance of the level of dividend growth.

Getty Images

Remember that investing, for the most part, is all about the long term. Therefore, don’t worry about the low current income, and instead focus on companies that have the highest potential to grow their dividends in the future.

Dividend growth investing has historically offered investors an opportunity to outperform the market with lower volatility. Despite the popularity of dividend yield, dividend growth has been a better indicator of outperformance relative to the broad equity market, and the magnitude of dividend growth should be considered as part of a dividend investment strategy.

After running the dividend analysis numbers, here are the companies we believe are poised to raised their dividends the most (according to in-house research and our proprietary methodology, DIVCON):

  • Visa (Ticker: V)
  • NVIDIA (Ticker: NVDA)
  • Texas Instruments (Ticker: TXN)

Click here to find out how you can identify the leading dividend growth stocks for your portfolio.

Visit www.realityshares.com for important disclosures.

About the Author

Eric Ervin, Investment Adviser Representative

Co-Founder, President, CEO, President, CEO, Reality Shares Inc.

Eric Ervin founded Reality Shares, a firm known for ETF industry innovation. He led the launch of investment analytics tools, including Blockchain Score™, a blockchain company evaluation system; DIVCON®, a dividend health analysis system; and the Guard Indicator, a directional market indicator. These tools were designed to help investors access innovative investment strategies as well as provide alternative dividend investment solutions to manage risk.

Most Popular

Dying Careers You May Want to Steer Clear Of
careers

Dying Careers You May Want to Steer Clear Of

It’s tough to change, but your job could depend on it. Be flexible in your career goals – and talk with your kids about their own aspirations, because…
September 13, 2021
5 Top Dividend Aristocrats to Beef Up Your Portfolio
dividend stocks

5 Top Dividend Aristocrats to Beef Up Your Portfolio

The 65-member Dividend Aristocrats are among the market's best sources of reliable, predictable income. But these five stand out as truly elite.
September 14, 2021
7 Best Commodity Stocks to Play the Coming Boom
commodities

7 Best Commodity Stocks to Play the Coming Boom

These seven commodity stocks are poised to take advantage of a unique confluence of events. Just mind the volatility.
September 8, 2021

Recommended

Kiplinger's Weekly Earnings Calendar
stocks

Kiplinger's Weekly Earnings Calendar

Check out our earnings calendar for the upcoming week, as well as our previews of the more noteworthy reports.
September 24, 2021
Tax Changes and Key Amounts for the 2021 Tax Year
tax law

Tax Changes and Key Amounts for the 2021 Tax Year

Americans are facing a long list of tax changes for the 2021 tax year. Smart taxpayers will start planning for them now.
September 23, 2021
ETFs and Mutual Funds with Todd Rosenbluth
Index Funds

ETFs and Mutual Funds with Todd Rosenbluth

Which is better: ETFs or mutual funds? And how do you decide where to put your investments? CFRA fund expert Todd Rosenbluth has some answers. Also, h…
September 22, 2021
11 Low-Volatility ETFs for a Roller-Coaster Market
ETFs

11 Low-Volatility ETFs for a Roller-Coaster Market

Volatility has nosed its way back into stocks, and that has investors sniffing out low-volatility ETFs. Just understand their strengths and their limi…
September 20, 2021