I love dividends.
Growing up I started investing with GICs and Canada Savings Bonds as a child when interest rates were around 10% (I turned down a 12% GIC at a credit union because I didn’t like the idea of having to buy a share of the union for $40). Naive me, I thought this was a standard ROI and dreamed of future wealth. Fast forward 20 years and the reality of GICs out pacing inflation by 1 or 2% sinks in they start to look a lot more like a wealth protection device than a wealth creation device.
I dabbled in stocks and lost 75% of my money during the tech boom.
That’s why I was so excited when I came across the ideas of dividend-paying (regular money payouts from the company to you the shareholder) blue chips (established companies). It seems to have ALMOST the long term stability of GICs, with the growth potential of the stock market. Pretty sweet.
One of the most fundamental ideas for good dividend stocks is the “Dividend Yield” which is how much you should expect to make on your investment in the next year (a dividend yield of 4% on $100 of stock means you should earn $4 in the next year through dividend payments). For Canadian companies, this dividend is taxed more favourably than interest income (the higher your tax bracket the bigger difference this makes).
Even more exciting is the idea that good companies should regularly increase their dividends. This is like a low-taxed GIC that will randomly increase its payout! There’s a small chance that the company will cut its dividend (which in addition to the lower payments would also cause the stock price to plummet), but that risk is the price for the more attractive gains.
Some people like to talk about “personal yields” which is the dividend-yield of a stock, based on the price you purchased it at. So going back to the above example, if the company increased their dividend payments by 25% to $5 and the stock price increased so that your shares were now worth $125, the dividend-yield is still 4%, but your PERSONAL YIELD is 5% (since you bought the stock for $100).
The fallacy with this outlook is that your shares are now worth $125. You’re ROI is $29 (29% in one year, not too shabby! Of course capital gains taxes would kick in when you sold, but still…), but if you decide to keep the stock and keep collecting dividends, there’s nothing magical about this “pile” of your money and the dividend-yield is still the same (if you like the looks of another stock that is paying 5%, the $125 might be better off there).
By bragging that your new dividend is 5%, you’re lumping the capital gains in with the dividend payments, which isn’t really rational.
Say I bought a GIC for $1000, invested it for a year at 4%, then reinvested the $1040 for 4% for another year. Am I earning 4% or 4.16% in the second year? Clearly I’m making 4%, I’m just confusing things if I want to lump in the $40 gains from the previous year. The only way to decide between buying another GIC or putting the money elsewhere is to ignore the past, look at the current value, and pick what looks like the best investment.
Landlords make a similar mistake when they buy a house and start patting themselves on the back about the financials after a decade. Rents should increase, and you need to compare them to the CURRENT value of the property to see how the property is doing as an investment, not the original purchase price.
Compounding is good, but don’t use it to fool yourself.
There’s probably an economic term for this fallacy, does anyone know it? I think the basic idea is when you segment your money and start looking at the “pools” as separate, you’re in self-delusion territory. If you want to evaluate an investment, factor in the CURRENT value of the vehicle, not the original price to determine the ROI going forward.