Last Updated on 15, August 2017
If you prefer to read, the following is the transcript of the video:
I have come across many young investors who invest in high dividend yield stocks. This is not appropriate for young investors due to three reasons:
First, as large part of company’s cash is distributed back to shareholders, little amount is left for the company to reinvest in existing and new projects. This means it has low earnings growth. What the investors is investing are low growth stocks. Many growth stocks pay little or no dividends. Moreover, investors should always consider the total return – which is the sum of capital gain and dividends collected. It is incorrect to focus on dividends while totally ignore the capital gains. For young investors, time is their friend. By focusing in low growth stocks, they fail to make use of the power of compounding.
Second, some people felt that “a bird in the hand is worth two in the bush”. They feel it is better to receive dividends which are real cash than to enjoy capital gains which are mere paper gains. Many investors fear that the companies which they invest may be mismanaged and thus it is better to get cash now than to enjoy a paper gain. The issue of the company collapsing is called non-systematic risks which can be completely eliminated through diversification. The issue of non-systematic risk should be address at the portfolio level. It incorrect to manage non-systematic risk at the stock level by demanding high dividends since non-systematic risk can never be removed at the stock level. Moreover, this “bird in the hand” approach is related to a human bias called ‘Self-Control’ which is well documented in behavior finance. Such a bias behavior tends to produce non-optimal decision making process.
Third, sometimes investors get confused between dividend yield play and value investing. It has been said that undervalued companies are sick companies which the market dislike. But I want to caution here that dividend yield play and value investing are not the same. A value investor seeks to look out for firms which have been mispriced by the market - dividend is not the primary focus. In fact, a loss making company which is unable to pay a single cent of dividend could have the potential to recover and earn a handsome profit resulting in huge capital gain for the shareholder when the market finally appreciate the true potential of the firm. Thus, value investing is not a high dividend yield investing although there is a tendency for high dividend yield investors to end up buying undervalued companies. Hence, those who are not careful could end up with a concentrated portfolio towards value investing although the primary objective was supposed to be dividends. Due to the greater risk in value investing, the investor may not be prepared for massive losses that could incur due to investing in ‘sick’ companies.
My advice to young investors is to expand their investment knowledge towards a more holistic approach than to narrowly focus on one school of thought. When in doubt, always consult a professional investment adviser.
Like this article? Subscribe to my newsletter below for more.