Dividend income investing to enable early retirement has been accepted as a core strategy to enable financial independence (FIRE). However, with the present economic turmoil due to the Coronavirus pandemic, perhaps it is time to reconsider going forward the risks involved in dividend vs growth investing.
In the U.K major businesses have cut or deferred £30 billion in dividends to shareholders to enable them to improve their balance sheets and weather the economic shock of Coronavirus. Virtually half of the FTSE 100 companies have either cut, reduced, suspended or deferred their dividend payments according to research by A.J.Bell. Further cuts may continue due to the U.K government imposing restrictions banning firms from using its loan schemes to distribute dividends to shareholders.
Big names such as Royal Dutch Shell, the biggest dividend payer on the FTSE, made its first cut since 1945, reducing its payout by two thirds. Also, the traditionally income reliable banking sector including HSBC, RBS, Barclays, Lloyds and standard Chartered announced in March this year that they would be cutting almost £8 billion in payouts.
Research by A.J.Bell discovered that 50% of retail investors have been affected by dividend cuts loosing on average 27% income. A further 20% had their income reduced by 50% or more. On a more positive note, they also found that 140 U.K companies will be retaining their dividends including 26 on the FTSE 100 such as GlaxoSmithKline, BP, L&G, Tesco and Diageo.
Overall payouts on the FTSE 100 fell by 45% year-on-year, and 76% on the FTSE 250. During the current crisis approximately 3/4 of U.K companies that usually pay a dividend have either cut or reduced them compared to 2/5 during the 2008 financial crisis. 2020 has been without question the biggest hit to dividends in generations.
What are the current and future implications?
The major fall in dividend income that has occurred and is potentially ongoing, could have a profound effect in several circumstances. If you are at the point of early retirement now and relying on a dividend income to fund your lifestyle, you could be at peril of having to cancel that because your investment income may not be sufficient to match your expenses with the current fall in payouts.
If the poor economic conditions and Coronavirus persist, low payouts could be an ongoing issue for some time. This means that based upon your prior assumptions, you may now no longer be able to afford to retire as early as you thought. Similarly, for younger income investors it may take much longer to acquire FIRE based upon an income reinvestment strategy, as the fall in dividend income will mean that compounding will less effective and your retirement pot will take much longer to grow.
Dividend vs growth investing – your options
A dividend investing strategy can be used in three different ways. Either, you can solely practice dividend investing during your accumulation and retirement phase or utilise growth investing for accumulation and switch to dividend income once retired. You can also use a blend of the two. The current annual dividend yield of the FTSE 100 is 4.81%, the FTSE All-share is 4.66% and the S+P 500 fluctuates but averages around 2%.
It now appears clearer that solely relying on a dividend income strategy may carry significantly more risk moving forward than it did before the Coronavirus crisis arose. There is still income to be found but it is not going to be as high or reliable as before. Index income investing could be a more prudent path to achieve income, through lowering costs and risk through diversification compared to investing in an individual stock portfolio.
Dividend investing has always been very popular as many people see it as ‘free money’ but income investing is not without risk. Solely judging a stock by its high yield holds dangers as businesses can often use this to hide more systemic issues within the company. Searching out high quality companies with strong balance sheets and a history of increasing their dividends is a sounder strategy and that recommended by Warren Buffett and others.
A benefit of dividend vs growth investing is that it can provide an income during bear markets when both income and growth stocks will suffer. This could be used as regular income, reinvested, or used to purchase growth stocks at low valuations. Dividend stocks can of course also experience growth resulting in additional investment returns but in general they are not ‘high-growth’. Research on the returns of dividend vs growth investments appears mixed with benefits to both methods.
Growth investing can lead to significant outperformance compared to dividends particularly in the short to mid term. The Dot Com bubble of the 1990’s is a classic example of this, and also the recent rise of tech stocks and Tesla in particular, during the current pandemic. Dividend stocks can’t really match growth stocks in terms of return when they are in a strong bull market.
Growth stocks can potentially be more volatile than income stocks as they can be subject to strong price dips when they become wildly overvalued. Some ‘growth’ stocks can still pay a dividend potentially, but in general they tend to be companies that invest their profits in R&D, expansion and M&A.
Although many stocks are still at lows following the market crash in the spring, the S+P 500 and the NASDAQ are at all time highs. With extensive global money printing taking place, particularly in the U.S, inflation could start to have an impact. This may result in investors seeking inflation-beating returns which could continue to power the stock markets rise.
By integrating both dividend and growth investing strategies you can harness the strength of each style and increase your risk management by being more diversified. How you do this will be a personal decision based upon your convictions, style, and attitude to risk. You could for example use a 80/20, 60/40 or 50/50 split similar to a stocks to bonds ratio to allocate the two styles to your portfolio, or whatever percentage you are comfortable with.
It cannot be denied that since the advent of Coronavirus the global economic landscape has profoundly changed. Although some indexes are at record highs, many stocks are at major lows and with mass unemployment and weak business and consumer demand in many areas the outlook going forward is very uncertain – potentially for a long period of time.
The debate over the benefits of dividend vs growth investing will continue but I think now is the time to be more cautious in your investing approach to manage risk more effectively and maintain a positive outcome. I would suggest that a blended strategy of both growth and dividend stocks in a low cost index fund is one of the best ways to achieve this.