When it comes to dividends, too much of a good thing is not wonderful. That’s especially important information for retirees and near-retirees, many of whom are substituting dividend stocks for some of their bondholdings. Their natural instinct is to gravitate toward those stocks with the highest dividend yields.
They should resist that instinct, however. On average over the long term, the dividend-paying stocks that performed the best were those whose yields were significantly lower than those with the absolute highest yields. Consider five portfolios that are constructed based on stocks’ dividend yields. The first contains the 20% of exchange-listed stocks with the highest yields, while the fifth contains the 20% with the lowest yields. The other three portfolios contain the quintiles of stocks in between these extremes. These portfolios are rebalanced once a year to reflect changes in relative dividend yields. The accompanying chart reports these portfolios’ annualized returns since 1927, courtesy of data from Dartmouth professor Ken French. Notice that the best return was produced by the second-highest yielding quintile of stocks—not the highest-yielding quintile.
To understand this counterintuitive result, you have to focus on dividends’ growth rate over the long term. A stock with a sky-high yield might look good now, but if its dividend doesn’t grow in coming years its contribution to your long-term return will be modest—or worse. Far better to pick a stock whose dividend is modest by current standards but which will grow faster over time. Citigroup versus Procter & Gamble There are many examples I could use to illustrate this point. Consider first Citigroup
which was one of the highest-yielding stocks in the S&P 500
before the global financial crisis. During calendar 2007, the company’s quarterly dividend was 54 cents a share, which translated to a 7.3% yield using the stock’s year-end-2007 price. During the financial crisis, however, Citigroup cut its quarterly dividend to a pe …