One for the geeks among you. Equities embody growth-seeking. But many people hope that they can use equity dividends as a component of their safety-oriented investments.
In Post #70 (http://donezra.com/70-three-goals-three-instruments/ ) I identified three kinds of financial goals we typically have once we stop working. One relates to longevity protection, that is, not outliving our future income. Investment instruments alone can’t totally satisfy this goal; there needs to be an element of insurance, since our lifespans aren’t certain. But investment instruments are useful for the other two goals, safety and growth, which I had discussed in Post #68 (http://donezra.com/68-safety-and-growth-as-investment-goals/ ). And the two investment goals are invariably in conflict: the more you want of one characteristic, the less you should expect of the other. In particular, I identified equities in Post #36 (http://donezra.com/36-historical-investment-return-patterns/ ) as having behaved like a good growth-oriented strategy. That means that you can’t rely on equity returns for safety.
Nevertheless, in this post I’m going to identify a portion of the equity return as being reasonably reliable from a safety perspective. It’s the portion of the return that comes from equity dividends.
What are dividends? They are essentially how profits made by companies are repaid to their investors. In fact it’s not quite as straightforward as simply paying back the profits. There are three things that companies tend to do with their profits: pay some of the profits back, as dividends; retain some, to finance new ventures in the future; and the catch-all, retain some as a contingency reserve. A reserve for what? For the two other purposes. There may be unexpected new venture opportunities, and it’s convenient for a company to have money on hand and not have to go back to its shareholders for more. And a reserve for years when the profits are lower than the last dividend payment, so that the dividend amount can be maintained even if profits are low or negative.
Investors like that last feature very much. In Post #67 (http://donezra.com/67-happiness-comes-from-certainty-about-not-outliving-your-assets/ ) we saw that human beings are hard-wired to like certainty. That fact reveals itself in many ways, one of which is that equities with reliable dividend streams tend to sell for a higher price (other things being equal) than equities with volatile dividend streams. And therefore companies (other than, for example, those describing themselves or behaving as “pure growth” companies) like keeping their dividends level or increasing.
It’s a fine balance between paying out such a high dividend that its maintenance is imperiled and paying out such a low dividend that a higher stream could be sustainable. So it’s not surprising to find that, from time to time, dividends are cut. But for a country’s equity index, representing a collection of its companies, somewhat greater stability is built into the dividend stream, because it tends to fall only when something negatively affects the economy of the whole country rather than a particular industry.
This suggests that an index’s dividend stream has the potential to act as a source of investment safety, at least partially if not fully.
There are some obvious questions to investigate historically. In particular, how often does an index’s dividend stream fall? And when it falls, by how much? And let’s look at those in real terms, that is, after inflation. We’re already used to the notion of real returns (from Post #36), and most of our income needs are expressed in after-inflation terms anyway since a lifestyle spending pattern can only be sustained if it keeps pace with inflation.
It’s surprisingly difficult to find historical data relating to equity dividend streams. One that does exist, fortunately, comes from the US S&P 500 index and a data series compiled by Economics Nobel Prize winner Robert Shiller.
The constructed data series goes back to the 1800s. I used the data starting with 1928, partly because that’s also the starting date for the data series I cited in Post #36, and partly because I wanted to make sure that the negative effects of the Great Depression are included. Here’s what I discovered when I analyzed it.
First, and most important: yes, the dividends do look fairly stable, in real terms. In fact, not only do they deliver an average real return that’s positive. They do better than that. Their average annual rate of growth is roughly 2%. (In other words, in real terms the amount of the dividend grows roughly 2% a year.) Compare that with the average Treasury bill real return of 0.5%, and it looks good.
How about its volatility?
The annualized standard deviation of the return series is 10.7%. That compares with 3.9% for T-bills, so dividend yield growth is less stable than T-bill returns.
How often is the growth rate positive? 63% of the years, compared with 61% for positive real T-Bill returns. Extending the time horizon to 5 years or 10 years doesn’t improve the prospects for T-bill positive real returns (strictly, it’s not the prospect but the history that I’m looking at), both producing around the same 60% outcome. But with the dividend stream for equities, extending the time horizon to 5 years shows that 69% of the time real dividend growth was positive, and periods of 10 consecutive years showed positive average growth 81% of the time.
Overall, then, my interpretation is that the S&P 500 index has historically produced a dividend stream that is somewhat better and more reliable, in terms of real return, than an investment in T-bills.
There’s one more question I asked myself. How large a dividend yield is reliable? For this I looked at the real dividend each year and checked what was the biggest drop. And here’s what I found. Over one-year periods, the biggest drop was 34%. Over 5-year periods, the biggest drop was 11%. And it was 4% over 10-year periods.
My interpretation of the one-year number is that, if you had started with two-thirds of the current dividend at any time, you could essentially have taken that amount as sustainable in real terms.
If you can create your own volatility reserve, as discussed in Post #71 (http://donezra.com/71-a-liquidity-reservoir-creates-flexibility/ ), for 5-to-10 year periods to cushion the one-year impact within those periods, then roughly 90-95% of the dividend yield has been sustainable, at least historically.
The equity dividend stream has an important potential use as a source of investment safety.
 See www.econ.yale.edu/~shiller/data.htm, then U.S. Stock Markets 1871-Present and CAPE Ratio, then data series ie_data.xls for real dividends.
 The arithmetic average is a little above 2% and the geometric average a little below 2%.
I have written about retirement planning before and some of that material also relates to topics or issues that are being discussed here. Where relevant I draw on material from three sources: The Retirement Plan Solution (co-authored with Bob Collie and Matt Smith, published by John Wiley & Sons, Inc., 2009), my foreword to Someday Rich (by Timothy Noonan and Matt Smith, also published by Wiley, 2012), and my occasional column The Art of Investment in the FT Money supplement of The Financial Times, published in the UK. I am grateful to the other authors and to The Financial Times for permission to use the material here.