The “Safe Dividend Stock” Illusion…

It is very common today to get a client or prospect asking about high dividend paying stocks.  It is perhaps even more common for many advisors today to include dividend stocks as a part of their lead pitch.  “We focus on high quality dividend paying stocks,” they might say.  This will undoubtedly lead to affirming head nods from the prospective clients.  And therein lies the problem.  This idea that high quality dividend paying stocks are a guaranteed smart investment with great upside and limited downside potential has become an axiom of sorts in the eyes of the general public.  No further data is needed; the safety of dividend stocks is self-evident.

But this is always where problems begin:  A general consensus among the investing public followed by hungry advisors wanting to capitalize on the latest trend (think late 90’s dot-com bubble).  I don’t think dividend paying stocks are near the problem internet stocks were, but it may be useful to take a more honest look at dividend stocks and remove the halo for a few moments.

An issue largely overlooked is the survivorship bias inherent in the glossy perception of dividend stocks.  An easy way to understand survivorship bias is to think of a clinical drug trial.  The trial starts with 30 patients.  In 10 years only 15 patients remain alive and they are in great health.  At this point the pharmaceutical company has a press release that states: “Great news! We have a new drug that gives marvelous results.  Out of the 15 patients currently taking the drug they are all in great health.”

You can see the problem.  As it applies to dividend stocks, investors have focused on how great the surviving dividend stocks have held up the past 5 years.  However; if we go back before 2008 and look at what was considered a top dividend paying stock then we might see a different story.

I did a quick Google search on “Top Dividend Paying Stocks” and limited the results to stories from 2007.  This just so happened to be one of the first search results I clicked on:

http://www.thestreet.com/story/10395997/2/the-top-dividend-stocks-of-the-week.html

It is an article from TheStreet.com, a very popular investing website.  To cut to the chase there are 8 stocks mentioned.  Here is the 5-Year Annualized Returns for 5 of those 8 with the S&P 500 Total Return for comparison:

When we include the fallen “top dividend stocks” the picture does not look as great.  57% of dividend-paying stocks reduced or eliminated their dividend from 2008-2009.  I have nothing against dividend stocks; in fact, they make up an important piece of any well diversified portfolio.  But only a piece.  There is no evidence that having a concentrated position in high dividend paying stocks will reduce risk or increase return.  The historical data actually suggests dividend stock returns have been about the same as non-dividend stocks so the only thing you really get by focusing primarily on dividend stocks is less diversification.

 

Everyone is susceptible to getting caught up in the current investment trends.  That includes me and every other advisor.  Human beings make terrible computers and are vulnerable to a wide range of emotional and cognitive biases.  Survivorship bias is one example of something we tend to overlook.  Grounding your investment philosophy in concepts with decades of collaborating data and academic research can prevent us from falling prey to these dangerous biases.