Why Dividends Matter

In a recent post we discussed how taking a total return approach to investing can have benefits relative to focusing on dividends when trying to generate income from your portfolio. Does that mean dividends (and the numerous funds and commentators who focus on them) are irrelevant? Not exactly.

Historically, stocks that pay higher dividends have outperformed stocks that pay low dividends or no dividends at all. And contrary to the investing principle that higher returns should go along with higher risk, higher-dividend stocks on average have actually been less risky investments. They’ve historically outperformed lower-dividend stocks in both bull markets and bear markets.

Source: BlackRock, via Business Insider

There are a number of possible explanations for this phenomenon. One hypothesis is that investors tend to overestimate that potential of high-growth companies, which also tend to be the companies that pay lower dividends (since the companies are choosing to use their money to try to grow their businesses rather than returning it to shareholders). As a result, the stocks of lower-dividend companies are often overvalued, so the subsequent returns are lower than for higher-dividend stocks.

Other possible explanations relate to how paying dividends affects companies’ decision-making. For example, it’s possible that having to consistently pay a dividend to shareholders keeps companies’ management more focused on only investing in profitable ventures.

That’s not to say that higher-dividend stocks always do better: there have been extended periods of time when they’ve underperformed lower-dividend stocks. And while some investors consider the collapse of internet stocks in the early 2000’s to be a warning against investing in high-flying stocks that don’t pay dividends, higher-dividend stocks are not immune from big declines of their own: banks were among the highest-dividend stocks in the US prior to the financial crisis in 2008.

So what’s the verdict? There’s no definitive explanation for why higher-dividend stocks have done well in the past, and there’s no guarantee that they’ll continue to outperform in the future. But there is compelling historical evidence that dividends do matter.