During financial consultations I am often asked by clients how they can invest in equities while still minimizing risk.
I always preface my response by explaining that there is no equity investment strategy without some risk. However, I assure them there is an approach I have used successfully, which has never failed to beat the S&P/TSX Index. That statement always gets their attention. What is this magical approach?
Investing in a well-diversified ‘basket’ of companies with a consistent track record of not only paying dividends, but also of increasing them annually, greatly reduces an investor’s market risk. Regular dividend payments reduce the negative impact of market corrections on a portfolio, while dramatically improving long-term returns. The proof? Consider the following comparative performances within the S&P/TSX Index over the challenging 10-year period ending December 31, 2009.
The total Index produced an average annual return of 5.6 per cent.
The non-dividend paying component of the Index averaged a 1.1 per cent annual return.
The dividend-paying stocks within this Index produced an average 11.4 per cent annual return.
Those dividend-payers with a track record of annual increases in their dividends produced an average annual return of 13.5 per cent.
These numbers assume that all dividends were reinvested as they were received. The clear conclusion from this is that dividends are an extremely important component of the total return achieved from equity investments. Regardless of which historical decade one examines, this has always proven to be true.
So how can an investor take advantage of this knowledge? Fortunately a number of Exchange-Traded Funds (ETFs) and Index Funds offer ‘baskets’ of dividend-paying, and even dividend-growing, companies. Many mutual funds offer similar investments, but with much higher investment and management costs which will usually erode some of the returns for the investor. All of these options are available for Canadian, U.S., and even some international markets.
The risk-mitigating advantages of dividend-paying equities are clear. However, even these investments are exposed to periodic negative market movements. For that reason, every investor must first determine what proportion of his or her total portfolio to allot to equities versus fixed-income investments, such as GICs, bonds, preferred shares, or diversified funds holding such securities.
I certainly sleep better knowing the equity portion of my portfolio is in ETFs comprised of more than 50 of the best dividend-paying companies on whichever index I choose, whether Canadian, U.S., or international. I know that even when markets fall, dividends cushion the decline of my portfolio. When markets rise, dividends enhance the gains. Although this strategy may not be risk-free, it represents for me the most prudent way to participate in equity markets, especially over a longer-term holding period.
A retired corporate executive, enjoying post-retirement as a financial consultant, Peter Dolezal is the author of three books. His most recent, The Smart Canadian Wealth-Builder, is now available at Tanner’s Books, and in other bookstores.
The information contained in this column is for information purposes only. The investment and services mentioned in this column may not be suitable for everyone.
Contact an independent financial advisor before making any investment decisions.