Dividends vs Portfolio Drawdown : Part 3

This is part two three (out of three) of our investigation into Dividends and their purpose, attractiveness and use for New Zealand-based investors.

• Part one: Should Companies Pay High Dividends?

• Part two: Is Investing for Dividends Bad for Long-Term Wealth?

• Or download the full research paper

While it's often assumed that cashing out dividends is a safer strategy than selling shares, this isn't necessarily the case. Cashing out dividends is akin to making a withdrawal.

Simply put, if you choose not to reinvest your dividends, you have effectively made a drawdown.

Dividend irrelevance has been known for over 50 years.

The theory originated from the influential work of Merton Miller and Franco Modigliani in 1961 “Dividend Policy, Growth and the Valuation of Shares”.

They argued that, in an ideal market without frictions like trading costs and taxes, investors should be indifferent between:

• A $1 dividend (which causes the stock price to drop by $1) and

• Obtaining $1 by selling some shares.

It's also important to remember that dividends are not guaranteed or reliable as they are subject to market conditions, company performance, and the discretion of the company’s Board.

They may fluctuate or even be cut during economic downturns or in case a company faces financial challenges.

In times of market downturns, investors might hesitate to sell their holdings. However, some may not realise that by not reinvesting dividends during these market conditions, they are effectively withdrawing from their investment portfolio.

The higher the dividends, the greater the impact on their overall portfolio.

Figure 3 below depicts the impact of cashing out dividends on the overall investment outcome by comparing:

• S&P/NZX 50 Price index: the series without dividends reinvested and the

• S&P/NZX 50 Gross with IC index: the series with dividends and imputation credits reinvested.

Looking at the S&P/NZX 50 Gross with IC series, it can be seen that, after the Global Financial Crisis (GFC), the market recovered and surpassed its previous peak within 5 years.

However, when dividends were not reinvested, it took nearly 10 years for recovery. The dotted lines in the chart represent the peak level before the impact of the Global Financial Crisis.

Another argument is that an investor should regularly drawdown rather than rely on the irregular and unknown amount of dividend payments.

This enables better household budget management and a higher standard of living rather than a windfall mentality.

To test this hypothesis, we conducted a study comparing the investment outcomes of two investors in an index fund tracking the S&P/NZX 50 index from April 2004 to April 2024.

• Investor 1: Received all dividends as cash

• Investor 2: Reinvested the dividends but made a monthly withdrawal of 0.45% of the investment portfolio's capital value

This ratio of 0.45% matches the average monthly dividend yield of the index during the 10 years from April 2004 to April 2024.

Suppose both investors had $10,000 as an initial investment amount and made no further contributions during the investment period of 20 years from 30 April 2004 to 30 April 2024.

After 20 years:

• Investor 1: Who cashed out all dividends ended up having a portfolio value of $19,214

• Investor 2: Who decided to make a regular withdrawal of 0.45% of the capital value of the investment portfolio could achieve $22,167

Reinvesting dividends for long-term wealth accumulation serves as a powerful strategy for investors seeking to maximise their returns and build substantial financial portfolios.

While the economic and fiscal environments might incentivise companies to distribute profits as dividends, most investors are advised to reinvest those dividends immediately.

By harnessing the compounding effect over time, reinvested dividends have the potential to significantly boost overall investment growth, ultimately leading to greater wealth accumulation and financial security for the future.

While dividends have their appeal, a strategic approach to reinvesting this passive income stream should be carefully considered.

Firstly, investing via a low-fee index fund would be more cost-effective than investing directly in NZ shares.

Secondly, regular portfolio drawdowns can often offer a more consistent and manageable income stream for those seeking long-term passive income

This method can be particularly advantageous over relying on the unpredictable nature of dividends, providing investors with a clearer financial pathway, and potentially enhancing the overall stability of their investment strategy.

Finally, if you are a higher income earner, PIE funds where taxes are capped at 28% allow investors to manage their investments more efficiently while minimizing tax obligations and having higher net returns.