If there’s a financial equivalent of cute kittens, it would have to be dividend stocks. The internet is fascinated with them — among other things, they dominate the google search rankings for financial terms, inspire countless forums and subscription services, and create an almost tribal loyalty among their adherents.

At the root of their spell is an aspirational quality. It is nice to imagine the possibility of living off the income that a stock portfolio throws off while never having to touch the principal, and still getting some price gains over time.

We’ve also been conditioned to believe that dividend stocks are somehow safer than those that don’t pay a dividend (or pay a lower one) since there is a real income stream behind them.

But is this fascination with the dividend-paying stock actually well-placed, or is the dividend dream just a bunch of marketing hype?

Let’s dig in, starting at with a look at how you might use dividend stocks in your portfolio.

Are Dividend Stocks a Better Source of Income Than Bonds in Today’s Low-rate Environment?

In today’s low interest-rate environment, one area where people are starting to talk about dividend stocks is as a replacement for bonds.

Before getting into why we do not think this is such a good idea, let’s first look at its logic.

Let’s say that you are retiring today and that you need to generate some income twenty years from now. Let’s look at three options:

1) You buy a 20 Year Treasury Bond at 2.5% yield. 2) You buy a 20 Year TIPs bond at a .4% real yield, resulting in lower initial income, but protection from inflation. 3) You purchase a collection of dividend stocks with a 3.5% annual yield.

It’s easy to see why people might rationally be drawn to the third option: not only is 3.5% a bigger number than 2.5% or .4,% but with dividend stocks you are also getting the potential for price appreciation, and if all goes well, that dividend should also increase at least at the rate of inflation, or maybe even a little faster if the companies you purchase are able to grow in real terms. So assuming the company whose shares you purchase keeps its earnings and dividends constant with inflation, you have a 3.1% a year annual return advantage from buying dividend stocks versus buying TIPs bonds (which is the fair comparison since the coupon payment also increases with inflation).

So what’s the flaw here? Well under most potential future states of the world, we would actually whole-heartedly agree that purchasing those dividend stocks is probably a better deal.

But the reason that you still want to own some bonds even in a risky portfolio, is that we aren’t certain just which of those future states is going to be ours. And in the worst-looking of them, bonds are going to do much better than either stocks overall, or dividend stocks specifically.

Let’s take a step back to the basics. When you purchase a bond, you are guaranteed to receive your principal back at the end of its term. Furthermore, you are guaranteed to receive interest payments at a set interval in the mean time.

With dividend stocks, neither of these statements is true. In economic recessions and depressions, companies can, do, and will cut their dividends. And stock prices obviously will fluctuate (they fell as much as 90% in the depression) so there is no guarantee that your initial principal will be intact when you need it. The experience of the 2008 financial crisis makes this clear: in a time period where dividend stocks (as represented by the DVY ETF) fell by over 60%, long-term Treasury bonds (as represented by the TLT ETF) were actually up 20%. So no, dividend stocks don’t make a good replacement for bonds.

Are High Dividend Stocks a Replacement for a Diversified Index Like the S&P 500?

If dividend stocks are a poor replacement for risk-free bonds, should you buy them instead of a diversified risk-y stock index?

Here, the evidence is more mixed, but our view would still be no.

First, let’s be clear that theoretically there is no reason that dividend stocks necessarily should outperform non-dividend stocks. If paying a dividend is really such a signal of value, you would think that investors would simply bid the prices of dividend-paying stocks up and/or the prices of non-dividend paying stocks down enough to equate their future returns. That is how things would operate in a rational world.

Nonetheless, you would get no argument from us if you argued that the world is not always rational. And, historically at least, it seems that high dividend stocks actually have outperformed low-dividend stocks on a total-return basis.

But actually, all value indicators look pretty good over history. In the past, shares of cheap (and often boring) companies have meaningfully outperformed those of glamorous high-growth companies, whether you measured this cheapness on the basis of cash flow, earnings, book value, dividends, or just about any other metric you could think of. Before betting on dividend yield, we might actually look at other metrics like free cash flow or price / book to make a value bet.

Neither is the future for all value strategies guaranteed to be as rosy as the past. Our guess is that dividend stocks in particular are now popular enough with individual investors that the return premium has now been almost entirely, if not totally, bid away. It’s also likely that value stocks got a boost from steadily falling interest rates over the past thirty years. While we are believers in value over the long term, we think there might be some hurdles to face in the intermediate term.

All that said, if you are in it for the long-term, we wouldn’t have a problem with making a small bet on dividend stocks, but we don’t think it’s worth spending too many neurons on it.

What About That Dividend Stock Magic?

What about the apparent magic of dividend-stocks that we mentioned at the beginning?

Again, a look at the fundamentals shows there is no magic here — only accounting.

When a company issues a dividend, it’s not creating value, it’s just re-assigning value from its bank accounts (which are owned by its shareholders) to its shareholders bank accounts. The key thing to realize is that the shareholders owned that value in the first place, just in a less direct form!

A company’s stock price should, and almost always does, instantaneously decrease by the amount of the dividend per share. That is because the company’s net worth has gone down by the same amount as the cash that it returned to shareholders.

If it had not returned that money to shareholders, the company could have done something equally (or potentially more) valuable with it, like investing it to grow its business more, or using it to repurchase shares of its own stock (which can be a more tax-efficient way to return money to shareholders, since by reducing the overall share count, it increases dividends per share, along with the stock price).

Isn’t it Better to Receive Income Then to be Forced to Sell Shares?

While it is psychologically appealing to never have to tap into your principal, it is important to realize that this is also a matter of accounting more than anything else. To see this, suppose your entire portfolio consists of 100 shares of a stock that is currently selling a $1 per share, and that you need to generate $5 from your income. If the stock pays a dividend of 5 cents per share, you are in luck — you don’t have to do anything but spend your dividend check.

If the stock pays no dividend, you would have to sell 5 shares of it. So if it pays no dividend, you end the year with 95 shares, and if it pays a dividend, you still have your full 100 shares.

It bears repeating that there is no magic here. When you calculate the dollar value of your portfolio, you are going to end up with the same number both ways. That’s because after the company pays the dividend in the first scenario, it’s share price will drop by 5 cents a share, so you now own 100 shares that are priced at 95 cents per share. And in the other scenario, you only own 95 shares, but they are still priced at $1 per share. It’s easy to see that the two scenarios are actually equivalent.

In fact, there are actually two important tax disadvantages to the company issuing a dividend.

First, if the dividends the company is paying are not qualified (taxed at a special rate), then you will get taxed at the ordinary income tax rate on your dividends, while if you had sold shares instead, you would get taxed at the lower capital gains rate.

Second, paying dividends triggers a taxable event whether or not you actually wanted a taxable event to be triggered. Suppose you didn’t want to take any money out of your investments in one year — if the company had re-invested the money, or used it to repurchase its own shares, then you would have been able to keep your money compounding tax-free for longer.

The second scenario gives you flexibility of designing your own dividend. If you don’t need income, you don’t have to sell anything (or pay any taxes). If you do, you can sell exactly the amount that you need.

Summary

In summary, some takeaways:

• Optically, dividend stocks seem attractive when compared to Treasury bonds in today’s low-rate environment
• Dividend stocks can be highly volatile though, so they make poor replacements for the role that Treasury Bonds play in a diversified portfolio
• Dividend stocks have outperformed non-dividend stocks historically, but it is unclear that this will continue in the near future
• Living off your dividends certainly sounds appealing, but it is not an objectively superior strategy to living off of your share sales, and in fact there can be tax advantages to the latter

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