Dividends were the original consumer retail investment -- sedate and predictable. The selling points for dividend yields were security, cash flow, and, in some cases, better returns. They're now a labyrinth of turns and wrong turns, and a dividend investment strategy needs real thought. History and new market modes have redefined investment dynamics, and the dividend strategy looks a bit out of place in the self-hyped investment market. While dividend investment is now seen as an all-round defensive strategy, it's actually a far more flexible option than that.
There are two equally valid arguments regarding dividend-based investment.
1. Dividends are wealth preservers as well as wealth generators. They're a defense against inflation, a cash flow, and an easily manageable capital base. Strong yields can provide a good working capital base for significant investment volumes. In effect, you can fund risk with your spare change -- provided the dividends deliver volumes. Over time, you can build your capital systematically.
2. Dividends can change quickly and drastically. The Fool's Todd Wenning wrote an article on the devastation of Wisdom Tree ETF dividend payouts during the global financial crisis in 2009. The article includes excruciating examples of the sledgehammer blows inflicted on dividends paid by top-of-the-line US companies. Typically, dividend behavior will also change with economic environment or even a change on a board of directors. Dividend policies generally don't remain static.
Case in point: Check out General Electric (NYSE:GE) for a good look at dividends as moving targets going up and down over time. GE did a real hatchet job during the financial crisis, nearly halving its payout in a natural defensive move in February 2009. This is a particularly realistic picture of dividend policy on the run, and investors need to be aware of the likely reasons for dividend polices as pure business moves, as well as investment issues.
Another, more investment-based example is Apple (NASDAQ:AAPL), which had a 17-year gap between 1995 and 2012 when it paid no dividends at all, and it went from a (split-adjusted) $0.03 dividend in 1995 to $2.65 when its share price peaked in 2012. This was an interesting total turnaround from previous policy, and the dividend has since risen slightly this year to $3.05. This move can be seen as both adding value for investors and supporting a high stock price -- another understandable business issue which often impacts stock prices.
Here are some pros and cons of a dividend investment strategy:
- Tying up capital: This particular cliche has a lot to answer for. "Tying up" is fairly hard to do in the modern market. "Tripping over your own money" is a more apt simile.
- Missing out on other investment options: This one is quite valid, to a point. Having a free hand to take advantage of good investment opportunities is just common sense, but why throw away a certainty for a theory?
- Dividends are slow-moving: True. That, in fact, was their original, ironclad recommendation to investors. Why kill yourself chasing every lead when you can make reasonable, secure money without even trying? People don't necessarily want "opportunities" that can leave them seriously carbonized.
- Dividend investments don't provide income between payouts: Well, duh. This statement isn't even right in theory. You can sell at a profit, for one thing. The truth is that pro traders buy in before ex-dividend dates (book closure dates for dividend payouts) at higher-than-average prices specifically to get dividend payouts. This is long-standing practice, and it's a good revenue-generator for traders.
- Diversification: Commitment of capital needs to be supportive of your overall investment strategy. Best practice is to diversify your dividend investments, mixing in growth objectives and capital gains. A good combination of both, in a diversified portfolio, is the unequivocally superior risk-management option.
A bit of modelling is in order here. When looking at dividend investment, you're looking at:
- Long-term and short-term values of dividends
- Cash flow
- Capital appreciation
Given the risks and rewards cycles above, you need to consider:
- Long-term goals
- Realistic cash-flow issues
- Your ability to fund your investments and build capital.
The famous "Rule of 72" equation says that if you get an average annual return of 7.2% on your investment, you'll double your money in 10 years. Dividend investments provide a good frame of reference.
You can do a lot better than double your money over time, funding your wealth creation in a controlled, sustainable way. "Sustainable investment strategies" is well on the way to becoming yet another annoying buzz phrase, but the real meaning is something you can reliably do with your capital to create wealth.
OK -- what's doable? Check everything.
- Can your dividend-based investments fund other ventures and allow you to take advantage of opportunities while keeping yourself secure? (In other words, can you see a way of having the cake and eating it, too?)
- Can you provide yourself with financial backup when you need it by keeping income-earning investments separate, and hopefully thriving, while you get on with business? (The idea is that your dividends can deliver support if you need it without compromising your investment capital base.)
- Can you see a few clear reasons why your investment choices will work to help your capital growth and support your investment moves?
- Does your dividend investment cover all the bases? Does it cover some of your costs or pay for things you want? (If not, it's a good indicator that you need better returns to make a dividend investment strategy work properly.)
Check your numbers. Are you covered properly? Can you expect a clearly laid-out income from your investments with no ifs, buts, or maybes?
Then get moving! You've found your combination!