Dividends put to the test 🦷
Hi folks, this article is intended to explain why a pure dividend-oriented investment strategy is not a panacea and why you, as the young whippersnapper that you are, should definitely reconsider whether you should really focus entirely on dividends and payouts with an investment horizon of more than 15 years.
Stop! What?
Dividends always make sense! After all, I regularly get money flushed into my account without having to do anything for it. In any case, I prefer to have the money directly in my hand so that nobody can take it away from me. And anyway, dividends are a sign of quality - if the company has paid out dividends for the last 20 years, it will continue to do so for the next 20 years.
Oh, and I want to live off my monthly cash flow in old age, so the portfolio can continue to grow in peace and I can live off the dividends! It's much better than constantly taking something out of the portfolio, because at some point I'll have nothing left. That can't happen to me with dividends!
Well? Who would agree with one or two of the above statements?
What if I told you that all of the above is a misconception, based on misinterpreted assumptions and that a dividend strategy can certainly have its pitfalls. In this article, we explain what you should keep in mind when implementing your dividend strategy.
If you want to do further research after reading this article, you can simply google the terms "Dividend Fallacy" or "Homemade Dividend Policy" and/or read the article by Gerd Kommer cited in source [3].
Introduction - Why are dividends so popular?
In times of zero interest rates, when we hardly received any interest on our savings, dividends were proclaimed a substitute for interest. The last time there was an average of just under 2% on overnight money was in 2008 [1]. There can certainly be no question of savers being spoiled in the last decade. So alternatives had to be found.
If saving no longer yields anything, then investments have to be made. In recent decades, the capital market has regularly generated higher returns than the interest paid. So what could be more obvious than declaring dividends the new interest rate?
It sounds totally simple. I buy a share that pays a dividend or an ETF that pays a dividend and I regularly receive cash into my account. It's tangible, quickly explained, easy to understand and generally a story that can be told. As the amount invested increases, so do the dividends. More money in, more money out. Zack, another story that can be told and shared on getquin.
getquin offers us the familiar opportunity to share our portfolios with other investors. There is a combination of words that is very common in the feedback we receive. We are talking about the desire for "monthly cash flow". Without exception, attempts are made to achieve this monthly cash flow by means of dividends. I would now like to take a step-by-step look at why the one has nothing to do with the other and what pitfalls await you when investing in high-dividend stocks.
So let's start by pulling out a few teeth.
🦷#1 - Dividends are free money
The dream of passive income, getting money for doing nothing. Or at least sit down once, make the effort and then collect money with a clear conscience. That is the goal of many investors. Dividend-paying companies come in handy here, because if I am invested in the company anyway and take the price gains with me, then I can also take the additional dividend paid. However, the fact that dividends are by no means free money becomes clear when we realize that the total return on a share price consists of two components:
Price yield + dividend yield = total return.
Example:
If a share has a price of €100 and has paid out €5 in one year, i.e. a dividend yield of 5%, as well as a price increase of 10%, the total return is 15%.
The same share would also generate a total return of 15% without paying dividends, except that the dividend yield would then be 0% and the share price return 15%.
In both cases, €100 would later become €115, except that in one case a portion is paid out and in the other case the money remains in the company.
Psychologically, we like the first option better. Technically, it makes no difference.
This is because both the share price yield and the dividend yield come from the same source: the company's profits. Even if the company does not pay out the dividend, it still remains part of the profit and will be reflected in the share price yield.
To claim that dividends are therefore free money is not true, because if you reverse the above logic and keep the distribution for yourself without reinvesting it, this is clearly at the expense of the total return, which ultimately leads to slower asset growth. We therefore pay the dividend at the price of the lack of return.
Reinvestment of dividends. This leads us directly to the next tooth.
🦷 #2 Once I have received dividends, no one can take them away from me
This statement is true. The money goes into your clearing account, so it's now yours. But what you do with it is absolutely crucial. If you leave it in your account or even use it to pay your gym membership fee, you reduce your return. Why is that? Because we have already learned under 🦷#1 we have already learned that without a dividend yield, only the pure price return remains. If this is not high enough or the discount on the dividend yield is very large anyway, this has a significant impact on our wealth accumulation.
ExampleAllianz
Let's take a look at the Allianz share price in 2022. Without reinvested dividends, the share price performance was -3.3%. With the reinvestment of the dividend, on the other hand, it is +2.0% [2]. So whether we use the dividend for the gym or put it back into the portfolio is the difference between victory and defeat, even over a one-year horizon. With a long investment horizon, the lower compound interest effect is even more noticeable.
As long as you have not yet reached your financial goal, you should therefore not consider using the dividends for anything other than returning them to the portfolio. If you reinvest the dividends in the same share, you are handing them over again and transferring them back to the company. So yes, a dividend paid out belongs to you, but you shouldn't keep it to build up your wealth.
🦷#3 The higher the dividend yield, the better
Every serious dividend investor knows that the dividend yield is not the only thing that matters when it comes to choosing dividend stocks for your portfolio. But why actually? A guaranteed yield of more than 10% sounds tempting.
The dividend yield is made up of the dividend agreed at the last Annual General Meeting and the current share price.
With a distributed dividend of €5 and a share price of €100, we have a 5% dividend yield. If our share gets into difficulties and loses 50% of its market value, the dividend yield is suddenly 10% with a share price of €50. We must now carefully analyze why the share has such a high dividend yield and whether the underlying price loss should be taken more seriously. No one wants to invest their money in companies that are doomed, even if they receive promising payouts. In the event of a sustained fall in the share price, it is not impossible that the dividend will be cut or canceled in the near future - in fact, it is very likely.
🦷#4 Dividends are a secure passive income
Let's come to the point where we take apart the phrase "dividends are the new interest" mentioned in the introduction. While interest is secure over the agreed period, at least in the case of fixed interest rates, dividends are by no means. Although it is possible to draw conclusions about the future from the past, none of them can be regarded as a given. Dividends are paid voluntarily by the company; the shareholder has no right to continued payment, nor can he prevent a reduction or even elimination if decided by the company.
There is therefore a clear difference in the recipient's entitlement between interest and dividends, but the degree of risk in one's own asset allocation also takes on a whole new level if an attempt is made to equate dividends with interest.
This circumstance can, but does not necessarily have to, lead to an expected payout being reduced or not made at all, which of course has an impact on the monthly cash flow to which the recipient is already accustomed.
🦷#5 It's the same whether I reinvest the dividends or have them reinvested myself
That's not quite right. Accumulation and reinvestment of dividends are not the same thing. Since taxation is handled differently for accumulation than for distribution, there are advantages and disadvantages here too.
Until 2018, an accumulating ETF benefited enormously from the so-called tax deferral benefit enormously. As no capital gains were accrued during the term of a reinvesting ETF until 2018, the entire gross dividend was reinvested and it was possible to benefit to the maximum from compound interest. Taxation was only due upon sale and was therefore deferred.
The introduction of the advance lump sum has put this into perspective to some extent. Nevertheless, the accumulator's tax burden is lower.
Below the tax-free amount, it really makes no difference whether the dividend is paid out or retained. All dividends are reinvested 1:1 in the ETF, in both cases.
The situation is different above the tax-free amount.
Distributing ETF:
Deposit value 01.01.: €100,000
Securities account value 31.12.: €110,000
Price gain: 10.000€
Dividend yield: 2.01%
Dividend paid: €2,010
Total return: 12.01%
Total profit: €12,010
Taxable (70% of the dividend paid): €1,407
Taxes payable (26.37%): € 371.03
Net dividend available for reinvestment: € 1,638.97
New portfolio value: € 111,638.97
Increase in value: €11,638.97
Accumulation ETF:
Deposit value 01.01.: € 100,000
Deposit value 31.12.: 112.010€
Total return: 12.01%
Total profit: €12,010
Advance lump sum 2023: 1,785%
Basic income: €1,785
Taxable (70% of the basic income): 1.249,50€
Taxes to be paid (26.37%): €329.49
New portfolio value: € 111,680.51
Increase in value: € 11,680.51
The accumulator therefore has a slight advantage when it comes to long-term asset accumulation. The difference in what remains after taxation, with the same price gains and returns, is around €42 for the accumulator with a portfolio value of €100,000. The dividend yield selected corresponds to that of the FTSE All World Dist.
The amount of the up-front lump sum or the underlying prime rate plays a decisive role in the whole calculation. In recent years, this has even been negative, meaning that the up-front lump sum no longer applies. According to Finanztip, an average up-front lump sum of 1.5% is realistic, i.e. slightly below the value used in the calculation for 2023.
We can also swap out other variables in the equation and look at a high-dividend ETF. The taxable portion grows, the price return suffers, as the comparison of the FTSE High Dividend Yield with the FTSE All World shows.
This is the reason why I would advise anyone who has a high-dividend ETF in their portfolio, is not dependent on monthly cash flow today and has an investment horizon of more than 15 years to reconsider this investment.
🦷#6 Dividend payments do not drain the substance of the portfolio
Let's move on to the most important point on the list and the main point of this article.
"Dividends are not necessary for a monthly cash flow". Why? Because both dividend payments and the sale of shares drain the substance of the portfolio. Why is that the case?
We fast-forward a few years into the future and are now about to retire. From now on, we want to reap the rewards that we have sown over the decades. Our portfolio has reached a value of €1,000,000 and we are looking at two withdrawal strategies. On the one hand, we improve in Account A our pension with 2% dividend distributions and on the other hand we sell in calculation B we simply sell 2% shares ourselves on a regular basis. In an initial analysis, we leave out taxes and transaction costs. I will come back to this later.
Calculation A
Deposit value at the beginning: € 1,000,000
Number of units in the custody account: 10,000 units
Unit value: €100
Distribution (2%): €20,000
Distribution per share: €2
Unit value after distribution (dividend discount): €98
Number of units after distribution: 10,000 units
-> Deposit value at the end: €980,000
Calculation B
Securities account value at start: €1,000,000
Number of units in the custody account: 10,000 units
Unit value: €100
Withdrawal via sale of units: €20,000
Number of units sold: 200 units
Number of units after withdrawal: 9,800 units
Unit value after withdrawal: €100
-> Deposit value at the end: €980,000
In both cases, i.e. both the dividend distribution and the withdrawal through the sale of units, our portfolio value is reduced. These findings also take into account the previously mentioned teeth drawn. Dividends are not free moneybut part of the company's profit, which simply does not flow back into the company but is paid out. The dividend discount ensures that our shares become less valuable and if we do not compensate for this by reinvesting the dividend, our portfolio loses substance.
From the perspective just considered, it therefore makes no difference whether I realize my monthly cash flow through dividends or replace it with manual withdrawals from the portfolio. Franco Modigliani and Merton Miller already made this observation in 1961 and provided an explanation as to why the dividend policy is irrelevant for the value of the company. A dividend payout could be replicated by the investor at any time, thus creating a so-called homemade dividend policy could be implemented [5]. The gentlemen were awarded the Nobel Prize in Economics for this work, among others.
But what does it look like when we take taxes and transaction costs into account?
First of all, I firmly believe that a lot will change over the next 30 years in terms of taxation, transaction costs and the sale of shares. It is almost certain that we will be able to set up withdrawal plans with our broker in the future. As we currently do monthly savemonthly, we will also be able to withdrawbe able to withdraw. This means that we don't have to be active ourselves every month or every quarter.
What about taxes?
Taxation will change, but let's look at the current situation: 26.37% withholding tax on capital gains and partial exemption on equity ETFs. Plus an allowance of €1000.
Does it make a difference whether I receive dividends or sell shares? No.
We pay tax on capital gains. Capital gains include both dividends and the sale of shares. Of course, we cannot compare apples with pears and assume the distribution/withdrawal from an ETF. Individual shares are therefore excluded. Again, the partial exemption applies to both variants. Just like the tax-free amount.
From today's perspective, neither variant has any tax advantages or disadvantages.
What about transaction costs?
Dividend distributions do not incur any transaction costs, whereas sales do. An advantage for dividends. But are the transaction costs so high that they are the death knell for our monthly cash flow from sales? That will depend firstly on the broker and secondly on what else changes in this area in the coming years. Today, sales are already free or cost just €1. With direct banks, you're quickly looking at 1%-1.5% of the payout amount. Doesn't sound so nice. However, with the withdrawal plans already presented, this could (subjunctive!) change in one way or another. Savings plans to build up a portfolio also follow a different cost structure than one-off purchases. Of course, inflation must also be taken into account for €1 transaction costs, but I for one consider transaction costs to be negligible today, and even more so in 30 years' time.
To reduce transaction costs, you could also switch to quarterly sales.
Conclusion
This article was not entirely altruistic. I wanted to answer the question of whether I would have to replace my initially selected accumulators in the near future. The purpose of the dividend also made sense to me, even if monthly cash flow has never appealed to me in any way. But it's better to think about old age today. In addition, the advance lump sum brings a new component into play that contests the tax advantage of accumulating ETFs over distributing ETFs.
However, with an expected average advance lump sum of around 1.5% (according to Finanztip), accumulators still have the compound interest advantage over distributors. Optimal, therefore, and still the first choice for me when it comes to long-term wealth accumulation.
And thanks to the knowledge I have gained, I can now also make withdrawals from the portfolio, knowing that dividends are technically nothing else. Psychologically, dividends may have a motivating effect. However, seeing the portfolio value and assets grow is motivation enough for me.
There may still be changes to come in terms of taxes and transaction costs, but even with the current variant there would be no significant disadvantages.
I therefore have a conclusion for myself for myself.
What can you take away from this?
A slightly different perspective on dividends!
Should you change your strategy now?
No. You should sit down and do your own calculations and research. In addition to the bare figures, your own strategy also includes your own psychology, risk appetite and investment horizon.
Why did I talk about an investment horizon of 15 years at the beginning?
Within the next 15 years, I would expect the taxes and costs that apply today. It would be negligent to speculate on changes. Since dividends do not incur any transaction costs and I personally would not want to hold a portfolio worth millions with a neobroker, I think distributors are the better choice for this situation.
With one, and above all myinvestment horizon of 30+ years, the situation is different. I go with the accumulator and manual withdrawal. This is my personal assessment.
Thanks for reading!
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Sources
[1] Tagesgeld - Entwicklung des Zinssatzes bis 2022 | Statista
[2] https://www.allianz.com/de/investor_relations/aktie/kurs.html
[3] https://gerd-kommer.de/dividendenstrategien-fakten-und-fantasien/
[5] https://m.diplom.de/document/227062
[6] https://finanzbiber.com/dividend-fallacy/
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