Risk and Reward: Dividend stocks offer balance

As with conventional farming, Dividend Farming means you are responsible for your decisions.  That statement is heady stuff during an age in which society often prefers someone else be responsible.

Successfully managing your dividend farm entails making decisions moving you toward your comfort zone along the risk / reward continuum.  Whether we know it or not, we all tend toward a general position on that span.

One end of the spectrum includes opportunities that are nearly risk free but offer few rewards.  For instance, burying your money in your yard reduces all but inflation risk which is the erosion in value of your money while it’s planted in a can in your garden.  There is no financial reward in burying cash.

The opposite end of the spectrum holds risky opportunities offering insane riches.  Lotteries are a perfect example.  You can play, but there’s little chance you’ll get your money back risking loss of your capital, even if it is only a few bucks.  However, if you’re the one among millions hitting the jackpot, you’re set for life.

Parking at one end of the spectrum or the other tends not to work well in the long run.  This is true in life and investing.  Consequently, most of us look for the sweet spot between those points.  It’s my contention that dividend paying stocks offer a great balance between low risk, low reward and high risk, high reward positions for the following reasons.

Total Return represents the dividends paid out by a company plus the appreciation in the value of the stock.  This means you have two value engines working for you – one is a cash flow stream and the other is the increase in stock price reflected in the open market. 

With strong dividend paying companies these engines work in tandem.  Higher valuations are generally tied to a firm’s ability to generate increasingly large sums of cash, much of which is then paid as dividends.  These dividends can be, and regularly are, increased by firms in the CCC list.

Non-dividend paying stocks have only the stock value engine in play.  In lieu of paying dividends, the cash is retained by the firm, reinvested to grow the company, hopefully increasing its market value.  This means that market value appreciation of non-dividend stocks must do the work of value appreciation plus dividend payments to achieve the same result found with dividend paying stocks. 

The implication is that the irrational behavior of Mr. Market can’t upend the cart if non-div stocks are to equal the total return of dividend payers.  In few endeavors is it advisable to bank on hope as a strategy, but from my perspective, that’s what happens with non-dividend paying companies.  Investors hope that value appreciation in the hands of Mr. Market will be equal to the task of value appreciation plus dividends, much less be sufficient to achieve their goals in the long run.

It’s safe to say I’d rather have two people working together to fill my wallet with coins than depend on only one.  What if the one gets hit by a bus?  Then what?  The fact that dividend paying firms aren’t single-threaded when it comes to returning your capital but have two channels through which that can happen strengthens the investment position.

 

Risk is the chance a threat of some kind materializes to do varying degrees of harm.  In simple mathematical terms it’s the probability of an event multiplied by the severity of the event.  For instance, if the probability of stubbing your toe in a dark room is 100%, but the room contains pillows and you’re wearing steel-toed boots, the severity of getting hurt is minimal.  Therefore the risk is low.  On the other hand, if that room is populated with legos, jacks, and hard wooden furniture with sharp corners and you’re barefoot, the severity of damaging to your toe becomes significant and risk goes up considerably.

The same premise holds with dividend paying stocks relative to non-dividend payers.  A dividend stock has two value engines working for it – dividend stream plus stock price increase.  If the stock price declines that doesn’t mean dividends will also decline and vice versa.  Under such conditions the severity of loss is reduced.  Conversely, the probability of a valuation decline for a non-dividend stock may be the same as a dividend payer but the severity of the loss is greater sans dividends.  Therefore, the risk associated with a non-dividend paying stock is greater.

Trade-offs involve exchanging safety and increasing risk for additional reward or the other way around.  Each of us need to consider which trades will deliver us the best possible outcome.  Non-dividend paying companies force investors to forego dividends on the premise their managements can invest the cash more productively than investors can if given the money.  There’s little choice in the matter.  I’d rather a company pay me a dividend letting me determine how best to spend or invest it.  Operating like this increases the control and accountability for my own decisions as a Dividend Farmer rather than leaving it in the hands of people who don’t know me from Adam.

On the flip side of the coin, failing to be an intelligent investor while retaining investment responsibility imparts risk that poor decisions will cost money.  However, we can mitigate that risk by continually learning, monitoring our investments, making rational decisions, and exercising patience along the way.

As an investor, you may not feel ready for DIY dividend investing.  There’s nothing wrong with that.  As mentioned earlier, each of us must find the sweet spot on the investing continuum of risk and reward.  We also need to figure out the means to get there – doing it ourselves or passing responsibility to a third party and hoping they don’t let us down.  You can have far greater positive influence on your future than you think.  It takes the Four Things a Dividend Farmer Needs to make it work and the persistence to make it happen.

The thoughts and opinions expressed here are those of the author, who is not a financial professional.  Opinions expressed should not be considered investment advice.  They are presented for discussion and entertainment purposes only.  For specific investment advice or assistance, please contact a registered investment advisor, licensed broker, or other financial professional.