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Dividend stock picking is the most compelling investment strategy that I’ve never tried.

I’ve been tempted several times over the years, including recently when we had some new money to invest. The arguments for holding more dividend-paying stocks are attractive. Dividends provide reliable income, and the total returns can be impressive. People I respect have made this style of investing work. Still, I don’t own any individual dividend-paying stocks.

Read on to learn why I hesitate, why I’m a closet dividend stock investor anyway, and why dividend stocks could still be right for you….

Beyond Passive Index Investing

In my book Retiring Sooner, I discuss four ways to get rich quicker: investing in yourself, starting a business, owning and managing rental real estate, and investing in the stock market. My preferred approach to investing in stocks is passive index investing. It’s the lowest-cost, highest-probability route for most people. However, as a rule, passive index investing is neither especially quick nor overly profitable. After all, its goal is to match market returns.

But it’s only natural to want to do better than the market. You can’t read financial news without being inundated with strategies, funds, and advisors who have recently outperformed the market, and are now inviting you to do the same. Yet, a time-tested principle of investing is that the only way to increase profits is to take on more risk. And that generally means dealing in more complex or specialized niches, and/or actively trading. I can’t recommend either. You’d be playing in a game of full-time professionals, one that is stacked against you.

In retirement, in addition to the ever-present desire to outperform the market, most of us add a strong interest in producing steady, reliable income from our portfolios. Dividend stocks are a viable route to enhancing your investment income and, in some cases, possibly enhancing your overall portfolio returns. But, as always, there is a price…

The Appeal of Dividend Stocks

Before we take a look at the drawbacks and details for investing in dividend stocks, let’s review the positives:

Choosing high dividend-paying stocks has been a staple of conservative, retired investors for as long as stocks have existed. With dividends, you receive regular payments while keeping your principal intact. In today’s environment, dividend rates can easily exceed what you could earn on bank savings by several percentage points. That’s a very appealing feature for retirees like myself. Unlike with a total return strategy (where you are relying on both dividends and growth and must harvest your principal periodically), with dividend stocks your income shows up regularly without any decision-making required on your part. It’s a retirement “paycheck.”

Another appealing aspect of dividend stocks, in contrast to income based on bonds, is that the income from a well-chosen portfolio of dividend stocks is likely to grow enough to keep up with inflation over long time spans. That isn’t because of any explicit mechanism, but rather due to the inherent nature of inflation — a general increase in the cost of goods and services. Businesses, after all, are the entities that provide those goods and services. And they are likely to raise their prices, and consequently their dividends, in the face of persistent inflation.

If you need more reason to consider dividend stock investing, try this: the strategy, though conservative, can actually outperform the broader stock market for extended periods.

My investing mentor Dick Young’s Retirement Compounders are composed primarily of companies with a history of dividend payments, and those with a long record of consecutive dividend increases. Since their inception in the early 2000’s, the Retirement Compounders have soundly trounced both the Dow and the S&P 500.

Why is this? It may be because most high-dividend stocks are also value stocks, which trade at a lower price relative to fundamental measurements (like earnings) than average stocks. Studies have shown that value stocks outperform growth stocks over the long term.

For me, the most powerful argument in favor of dividend stocks may be the discipline they impose on company managements. Call this “show me the money.” Dividend payments commit managers to delivering measurable value to stockholders on a regular basis. Dividends may not be as glamorous, but they are more certain than investing in research and acquisitions, or engaging in stock buybacks to pump up stock prices.

The Drawbacks of Dividend Stocks

But dividend stock investing is not without its drawbacks. Otherwise I would have committed to the strategy long ago.

The biggest issue, I think, is that it requires significantly more time and expertise to implement than passive index investing. It may not be as demanding as active trading, but it still requires winnowing a universe of thousands of common stocks down to a few dozen that meet the necessary requirements for sustaining high dividends. You need a filtering system, and implementing one is not for the hobbyist, in my opinion. This is not a “couch-potato” or “set and forget” investing regimen. Choosing safe dividend stocks requires a non-trivial commitment to analyzing individual companies and their businesses.

Once you’ve selected your dividend stocks, managing them requires discipline and organizational skills. You’ll probably need to own a few dozen stocks to achieve reasonable diversification. That could mean a hundred transactions or more in your investment account over the course of a year, as each of your many dividend stocks issues its ongoing payments. That doesn’t bother everyone, but to me it’s a lot of activity to monitor. And certain high-dividend stocks like Master Limited Partnerships add additional tax complexity that will only “help your accountant send his children to college.”

A more serious drawback to dividend stocks is the potential for taking on extra risk due to lack of diversification. Companies that pay high dividends tend to be concentrated in a few potentially volatile industries such as finance, real estate, energy, and utilities. What happens to your dividends during the next banking or real estate melt-down? What if the government makes wholesale changes to energy policies or utility rates?

While dividend cuts are rare, they can certainly happen, especially during economic downturns. Dividends enjoy no guarantees. When you buy a dividend stock you are taking on more risk to get a generally higher yield. CDs are insured by the FDIC. For a bond to reduce or eliminate its payment requires a default — an event with serious legal consequences. But for a stock to reduce or eliminate its dividend simply requires a vote by the company’s board of directors.

As mentioned above, dividend stocks tend to be value stocks so you will be overweighting that style compared to growth stocks. This may deliver better performance over the very long haul. But understand that there will still be periods when value stocks are out of favor. If you need to draw on principal during one of those times, you could be hurt.

Finally, though I don’t make investment decisions based on tax issues, it’s important to note that ordinary dividend income gives you less tax flexibility, and possibly higher taxes, than harvesting principal on your own schedule and paying taxes on the resulting capital gains. In particular, if you are a retiree in the 15% or lower tax bracket, you can now generate tens of thousands of dollars in income annually by taking long-term capital gains, and pay no taxes!

Dividend Stock Picking

If you’ve read the drawbacks above and are undeterred, if you think dividend stock investing might be for you, where do you start? Well, The Intelligent Investor is the classic that heads many value investors’ reading lists. Beyond that, I can best point you to my own mentors and colleagues….

Todd Tresidder at FinancialMentor recently ran a guest post detailing a full model for choosing dividend growth stocks. It’s a systematic method touted as “relatively straightforward” to implement, though it still requires running stock filters, reading company financial statements, and performing technical analysis. I can’t vouch for it personally, but I respect Todd’s opinion, and expect it’s worth a look if you’re interested in the concept. The author, Mike, also runs the Dividend Stocks Rock and Dividend Guy blogs, where you’ll find more details on his system, profiles of attractive dividend-paying stocks, and sample portfolios. Another nice, thorough introduction to the topic is Passive Income Dividend Investing by Joseph Hogue, CFA at his MyStockMarketBasics site.

My investing mentor Dick Young publishes an investment newsletter, Intelligence Report, that I’ve subscribed to for decades. It’s a mixture of economic commentary, low-cost buy-and-hold passive index investing philosophy, and dividend value stock picking. Dick maintains a “Master List” of recommended common stocks at all times, most of which pay solid dividends. But even if you subscribe to and read his newsletter religiously, choosing and managing your own basket of dividend stocks can be challenging and time-consuming.

Compromise: Dividend-Oriented Funds

If you’re intrigued by dividend stocks, but don’t have the time or expertise to fully commit to the strategy, what can you do instead? One reasonable approach is to buy dividend-oriented mutual funds or ETF’s. Here is a representative sampling that I would investigate if I were in the market for a dividend-oriented fund:

NameSymbolSEC YieldExpense Ratio10-Year
iShares Select Dividend ETFDVY3.21%0.39%6.37%
PowerShares High Yield Equity Dividend Achievers PortfolioPEY3.28%0.55%N/A
Schwab U.S. Dividend Equity ETFSCHD2.90%0.07%N/A
Utilities Select Sector SPDR FundXLU3.27%0.16%9.24%
Vanguard High Dividend Yield ETFVYM2.98%0.10%8.29%
Vanguard REIT ETFVNQ2.72%*0.10%8.60%
Vanguard Wellesley Income Fund Admiral SharesVWIAX2.66%0.18%7.42%

(Note: These are not recommendations to buy. Data is current as of this post date and should be confirmed before making any investment decisions. *=Adjusted Effective Yield)

A mutual fund or ETF gives you one-stop-shopping and relieves you of choosing and managing individual dividend stocks. But, as you can see from the yields above, it is difficult to maximize your income without assembling a portfolio of individual stocks. Right now it is difficult to put together a yield much higher than 3% using a fund.

I’ve owned Vanguard’s Wellesley Income for many years, and you could say it is my proxy for dividend stocks. Though Wellesley Income is usually about 60% invested in bonds, its remaining stock holdings are primarily companies that have paid a larger dividend or that have expectations of increasing dividends. Wellesley has long been my “go-to” investment. For a conservative fund, one that produces consistent returns and limits downside volatility, it has performed remarkably well over the years.

Why I’m a Total Return Investor

Vanguard, champion of long-term low-cost investing, has tended to favor a total-return over an income or dividend approach to investing. Their 2007 study Spending From a Portfolio: Implications of a Total-Return Approach Versus an Income Approach for Taxable Investors found that “Compared with the income-only approach, the total-return approach is likelier to increase the longevity of the portfolio…” Some disagree, but still don’t find any inherent superiority to a dividend approach for generating risk-adjusted returns.

A more recent study from Vanguard drives home that dividend-paying stocks are nevertheless stocks, and continue to carry the risks of high volatility and loss of capital. While they are less volatile than the broad stock market, they are far more volatile and less predictable than bonds. Plus dividend stocks are no longer the domain of a select few conservative investors. Increasing demand has driven prices well above the long term average, making dividend stocks less of a “value.”

Finally, Vanguard analyzed the return from income and capital for five buckets of equity funds ranging from high to low yield. Regardless of the yield, the total returns for the 20 years ending in 2011, were virtually identical. Dividend stocks held no edge.

The main reason that I’m not currently a dividend stock investor is that it just isn’t representative of how I succeeded in becoming financially independent and retiring early. I did that largely through buying and holding broad-based, low-cost mutual funds. I know that approach works, and I’m very hesitant to “change horses” at this point in the race. Nor is dividend stock investing a viable strategy going forward, when I need to be simplifying and streamlining my portfolio, putting it on autopilot for our later years.

My mission on this blog is to communicate a simple model for saving, investing, and retiring. Buying the broad market and relying on total returns is a high-probability approach that can work for anyone, from the 20-something college graduate, to the 60-something retiree.

That total return approach is arguably less risky too, because it diversifies among both income and capital appreciation. Yet the appeal of dividends is strong. That’s one reason my portfolio is nearly one-third in Vanguard Wellesley Income. My approach incorporates dividends, but is balanced. I love seeing those dividends arrive every quarter. But I’m also comfortable assuming that, in my diversified portfolio, there will always be an asset class in favor, should I need to harvest some principal at a profit….