Don't rely on dividend strategies to pick stocks

Yesterday, we saw why substituting a dividend-paying stock strategy for a high-quality fixed income strategy isn't a good idea. However, many investors are married to the idea that investing in dividend-paying stocks is a good idea for the stock portion of their portfolios. Today, we'll see why that isn't a good idea, either.

The two strategies we examined involved investing in stocks with high dividends and stocks with fast-growing dividends. Let's take a closer look at those two strategies.

When we examined a high-dividend stock strategy, we saw that it was really not much more than a large-cap value strategy. The SPDR S&P Dividend ETF (SDY) had more exposure to the value factor than the Russell 1000 Value Index, which is a large-cap value index.

To compare the strategies, we'll use data from the website of Ken French, a Dartmouth professor and director of investment strategy at Dimensional Fund Advisors. For the period 1928-2011, a high-dividend strategy had an average annual return of 13.6 percent, compared to a 14.6 percent return of a U.S. large-cap value strategy. As we saw yesterday, the high-dividend strategy has lower market exposure than the Russell 1000 (0.66 versus 0.94), which resulted in a lower standard deviation (23.3 percent versus 27.1 percent for the large-cap value strategy).

The Sharpe ratios, which are a measure of risk-adjusted returns, were virtually identical at 0.43 for the high dividend strategy and 0.42 for the large value strategy.

With fast-growing dividends, we saw that such a strategy isn't much different from holding an S&P 500 Index fund. The Vanguard Dividend Appreciation ETF (VIG) even matched the S&P 500's exposure to the size and value factors.

Because of the high interest in this strategy, I decided to dig a bit deeper into the strategy. With assistance from the research team at DFA, we did a quick test in which we started in 1980 and calculated the annual dividends for all the ordinary common shares in the CRSP files. This allowed us to calculate dividend growth rates starting in 1981. We then calculated cap-weighted annual returns for the top 20 percent of the dividend growth ranking each year. Since the growth rates start in 1981, the returns start in 1982. This gives us a 30-year time period for the analysis.

For 1982-2011, the top 20 percent had an average annual return of 12.5 percent and a standard deviation of 17.6 percent. For the same period, the CRSP total market index had an average return of 12.3 percent and a standard deviation of 17.7 percent. The t-statistic (which measures how significant the finding is) on the return difference is 0.21, meaning the difference isn't statistically significant. (Generally, it has to be more than 2 to be statistically significant.)

For the full period, the group provided an annualized return of 11.1 percent versus 10.7 percent for the CRSP total market index. Note that the S&P 500 returned 11.0 percent with a standard deviation of 17.3 percent for the same period. Again, not much of a difference.

There are lots of myths out there. Among them is that high-dividend strategies are good substitutes for safe, fixed income investments. PIMCO's Bill Gross agrees, cautioning about substituting dividend-paying stocks for Treasuries as there's a "huge gap of risk" between the two types of assets.

Another of the myths is that investing in stocks that produce rapid growth in dividends produces superior returns. The evidence presented demonstrates the truth of the statement that just because millions of people believe a foolish thing, doesn't make it any less foolish.