The Cult-Following of Dividend Stocks Reveals a Major Failure of Financial Literacy

We need to talk more about how to turn assets into income

People who give financial advice online ignore 50% of wealth management.

Every financial advisor and online finance writer has tips on how you can accumulate wealth. Very few provide public advice on how you can use your wealth to fund your lifestyle AKA “retirement spending,” AKA “wealth decumulation.”

As highlighted in this recent Twitter exchange I had with a popular advisor:

“We spend our time learning how to turn income into assets, but few people talk about how you can turn your assets into income.”

If you think saving for retirement is hard, try turning those savings into a reliable income stream that will last the rest of your life.

This is the first entry in a special 2-part edition of the calling Financial Bull$hit, where I tackle what might be the most under-discussed question in all of personal finance:

How do you turn your retirement savings into retirement income?

All we have to help us figure out retirement income is one extremely flawed rule of thumb

You spend your whole life building a (hopefully) giant pile of money which we call a “retirement fund.”

Saving that pile of money is simultaneously incredibly hard but fairly simple. Put money aside every paycheck, invest it, and let it compound for a few decades.

A much more complex question is, how do you turn that pile of money into a reliable stream of income that will last you the rest of your life?

When it comes to building your pile, financial advisors and financial writers like me have all sorts of advice. But on the subject of living off the wealth you accumulated, the only popular piece of advice seems to be the 4% rule, which says you withdraw 4% of your pile of money in your first year of retirement and increase that by inflation each year.

In a previous post, I detail the many shortcomings of the 4% rule. If you have not read that post yet, I recommend you read it and come back.

Since we don’t talk about retirement income, we turn to “income” investments

The absence of financial advisors — who know what they’re talking about — providing free tips on how to build reliable income streams in retirement leaves us with an information void.

Who do we have to fill that void? Finfluncers who gravitate to “income-oriented investments.” My social media feeds are infested with accounts solely dedicated to talking about dividend investing — which is a tactic where someone buys shares in a company that is known to pay a strong and consistent dividend.

It’s pretty easy to understand why dividend investing has such a cult following.

Turning your retirement savings into retirement income is complicated, and nobody seems to talk about it. Then you see these people bragging about their dividends and how they plan on living off that “passive income,” and you think to yourself, that sounds pretty appealing.

But, as I wrote about in-depth in The Rational Investor, chasing dividends and yield is an inefficient way to invest your money.

The rational investor cares about one thing; total investment returns.

Total returns for stock market investors = capital gains + dividends — investment fees & taxes

All that matters is, what is my account balance? If you have a $100,000 portfolio, the $100,000 is all we should care about. We shouldn’t care whether that $100,000 came from dividends or capital gains (increase in share prices).

Dividends feel like “free money,” but they’re not.

If you want to buy tickets for a concert that add up to $500, the tickets will still cost you $500 of your portfolio whether you choose to make the purchase using dividends or by selling a few shares and using capital gains.

Income is income.

However, most investors are not rational, and they have a firewall in their minds that separates dividends from capital gains.

Dividends are viewed as “real” money that can be spent.
Capital gains are viewed as “temporary” money that should not be touched.

As I have covered in the past, loss aversion is powerful.

The simple act of choosing to sell shares feels like we are losing, but taking dividends when they are given to you feels good. But again, this is silly. If you need $500, it does not matter if that $500 came from a dividend or capital gain.

Dividend investing also has two fatal flaws.

Dividends are tax-inefficient — especially during your working years.

Dividend investing will reduce your total returns because it forces you to pay taxes when you shouldn’t. As an investor, you have zero control over the dividend policy of the companies you invest in. They will pay you the dividend on a regular schedule — whether you need the money or not.

If you’re working and you invest in dividend stocks outside of tax-sheltered accounts, you’ll pay tax on those dividends — and if you’re in a high-income tax bracket, you might pay a lot of tax.

But, with capital gains, you only pay tax when you sell. If you don’t sell, you could make $10 million per year, and you still won’t pay tax on your unrealized capital gains.

2. Dividend-focused portfolios are under-diversified.

The number of stocks in the global market that pay dividends has been steadily declining for decades

In 1991, 71% of global stocks paid dividends.
By 2012, only 61% of global stocks paid dividends.

Focusing exclusively on stocks that pay dividends means you are excluding 40% of the global stock market from your portfolio.

Dividends are not “free money.” They are an inflexible, tax-inefficient way to receive investment income while reducing the diversification in a portfolio.

Focus less on passive income (dividends) and more on passive wealth (capital gains + dividends).

I know what you’re thinking…

So, if dividend stocks aren’t the answer, how do you turn your retirement savings into reliable retirement income?

This is an enormous topic, and instead of writing one 5,000+ word post, I have chosen to break this into two parts.

In this first entry, I reviewed why overly simplistic solutions like the 4% rule and dividend investing are inefficient ways to turn retirement savings into retirement income.

Stay tuned; next week, I will release a detailed “retirement income 101” guide.

Want to learn more about investing?

Here are three resources:

This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.