investing

Dividend Investing Won't Work

December 20th, 2014

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This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.

Poker table: Investing is a lot like poker. Drawing analogies from poker helps to explain why simple investment strategies such as dividend investing don't work.

Many people today like to invest in higher yielding dividend stocks. In this series, I explain the reasons why I'm not a fan of this approach.

In ourlast installment, I explained why dividend stocks aren't any safer than other stocks. In this article, I will explain why I think you shouldn't follow the dividend investing strategy, or any other simple investing strategy for that matter.

The Perceived Advantages Of Dividend Investing

Let me ask you a simple question. Why do some people follow the dividend investing strategy?

Here's a few reasons that I see dividend investors give: "Because it provides a steady income", "Because they're tax efficient", "Because dividend stocks won't become unreasonably cheap", etc.

You can divide every reason into two buckets: A) Safety, and B) Higher Returns.

For example, "Because it provides steady income" belongs in bucket A) Safety. The person is expressing the hope that no matter what happens, dividend stocks will generate decent returns.

On the other hand, "Because they're tax tax efficient belongs in bucket B) Higher Returns. Keeping more of the profits away from the tax man leads to higher returns on investment.

The Whole Point Of Following An Investment Strategy

In fact, you can divide every reason for following any strategy into these two buckets of Safety and Higher Returns. That's because there's only one metric - only one! - that matters when you evaluate any investment strategy:

Future returns relative to risk.

Remember, you receive return on your investments in exchange for taking risks. Winning strategies promise higher returns for the same risk, or the same returns for lower risk. That's it._
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Going back to dividend investing, it doesn't matter whether you make money through dividends or through capital gains (i.e. appreciation in stock prices). The bottom line is, if you're a dividend investor, you think dividend investing generates higher returns relative to risks, than you would by following some other strategy.

Otherwise, there's absolutely no point in following the strategy. You might as well just buy broad market index funds.

Similarities Between Investing And Poker

Investing is a lot like poker. Everyone is playing for higher returns relative to risk, but there's only so much of this 'return' to go around.

The average investor performs average. You can't change that - it's mathematics. So everytime someone wins higher returns, someone else loses relative to the market. Kinda like how when you win a hand of poker, you take your winnings from someone else.

Anytime you buy a stock, you buy from a willing seller who in turn thinks that the better decision is to sell. It's your wit against his/her's.

Why Simple Investment Strategies Don't Work

Let's suppose that dividend investing really did 'work' - i.e. it got you higher returns relative to risk, than by following some other strategy.Do you think the other investors wouldn't have noticed?

Of course they have.

The dividend investors just took some wins at their expense - i.e. they received lower returns relative to risk. What do you think the chances are, that they'll just sit by and let you keep winning?

Zero.

If the strategy really did work, these other investors will all follow the same strategy themselves. More and more investors will follow the strategy until the strategy doesn't work anymore because everyone's doing it.

This, by the way, is the reason why so many people believe in Efficient Market Hypothesis. Now, I took pains to explain why I think the hypothesis is wrong, but I agree with the efficient market crowd in one respect:

You can't expect a simple strategy to give you superior investment performances over the long run.

Simple Vs Complicated Strategies

Note that I emphasize the word 'simple'. If a strategy is simple, anyone can replicate it. That's why it won't work. On the other hand, if a strategy is complicated and/or non-intuitive, many other investors won't (successfully) replicate it. Therefore, only complicated strategies have a chance of getting you better than average investment results.

That's precisely why some value investors can consistently do better than the market. Value investing is complicated. There's a lot of art as well as science mixed in. Both aspects are hard to learn. Because of this, many "value investors" fail, because they fail to apply their analysis correctly.

Ask Yourself - Who Is The Sucker?

In poker, there's a famous saying.

"Look around the poker table; If you cant see the sucker, youre it"

When you choose a strategy or a particular stock, ask yourself. Who is the sucker? Why is someone selling you stock at the price that you're willing to buy it at? If you can't properly answer this question, think again about investing.

Unfortunately, I don't think most dividend investors today ask that question at all, and that's why I personally think that dividend investing will disappoint many people in the days ahead.

This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.