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Dividend stocks aren't fail-safe

Dividend investing has many sterling qualities but protection against downturns is not one of them. With few exceptions, dividend stocks fall just as hard as other stocks when the market crashes.

Yet despite that failing, you should still own dividend stocks. Let me explain why, with the help of Dartmouth professor Kenneth French.

His data show that U.S. stocks with high dividend yields have outperformed the market over the long term.

In one study Prof. French sorted dividend-paying stocks by yield into five groups plus a sixth group that tracks non-dividend payers. He looked at the returns an investor would have reaped if he or she had bought each group, held them for a year, sold them, and repeated the process over and over.

The long-term returns are shown in this accompanying bar graph.

Dividend Gains
[larger version]


The group of stocks with the highest yields gained an average annual return of 10.9 per cent and bested the market by 1.6 percentage points a year from the summer of 1927 to the end of 2011.

However, the highest yielding stocks didn't produce the best returns. It was the second highest yielding group that fared best, with average annual returns of 11.8 per cent.

What's behind this quirk? Extremely high yields are usually a sign of distress rather than strength. Should a company run into trouble, its share price often tumbles, pushing its yield into the stratosphere - until management cuts the dividend to save money. It's a sequence that Yellow Media shareholders recently learned about the hard way.

On the other hand, buying stocks that don't pay dividends is also risky. In Prof. French's study, they underperformed the market by a percentage point a year.

The moral here: It pays to be a yield hog but not a greedy one.

It also pays to keep your expectations in check during tough times. Returning to Prof. French's data, we can track the performance of the second highest yielding group during bear markets. Declines from prior peak levels are shown in the accompanying graph along with the declines of the market as a whole.

Dividend Downside
[larger version]


You can see that the experience of dividend stocks is quite similar to that of the market in down times. They didn't save investors during the grand daddy of crashes in 1929. Nor did they help investors much when they were licking their wounds in 2009. Dividends are not sure-fire bear repellants.

Mind you, they helped a bit on a few occasions. They cushioned the downturn of 1974 and dividend investors largely avoided both the growth, and the burst of, the Internet bubble more than a decade ago.

Overall, the notion that dividends protect investors during downturns is less than convincing. But they have provided a nice return advantage over the long term. So while both dividend investors and index investors might cry into their beer during bear markets, at least dividend investors can afford more expensive hooch.

First published in the Globe and Mail, April 21 2012.

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