High yield dividend stocks: Performance and their contribution to diversified portfolios

Dividend yields in the stratosphere grab our attention. For example, MPLX’s (MPLX) recent yield was 16% and Energy Transfer’s (ET) was 21%. With the 10-year S&P 500 Index average dividend yield around 2.35% and the 10-year Treasury yield less than 4% for the same period (and less than 1% in the last year), high yield dividend stocks can tempt investors. But these extreme yields are for speculators – not investors – because they almost always come with extreme risks, too.

Investors can still find high yield dividend stocks that should impose far less risk. Examples include AT&T (T) (recently 7.1%) and Simon Property Group (SPG) (recently 7.9%). These can be useful investments for preservation-minded investors seeking income because, in the aggregate, these stocks’ returns can be less volatile than the returns of lower-dividend stock returns. Even growth investors might benefit. For dividend investors and non-dividend investors alike, it’s important to understand the following question: Do high yield dividend stocks have a total return on par or better than that of the broad index such as the S&P 500 Index?

High yield dividend stocks backtest study

To address this question, we conducted a back-testing study using stocks considered high-dividend payers in 2010. The main database source is 32 surviving components of the Dow Jones EPAC Select Dividend Index whose dividend yields exceeded 4% for the year ending 31 August 2010. Financials and utilities dominate this index. To sample under- or unrepresented industries, the database includes a real estate investment trust, a healthcare stock, and a pipeline that were not included in the index in 2010. The method uses a total of 35 high-dividend stocks, it assumes an equal allocation to each high-dividend stock, and it analyzes returns through 17 September 2020.

Investment Return Results

• The S&P 500 Index mean annual total return equals 14.64%.
• The high-dividend stock mean annual total return equals 12.42%. Only 7 of the 35 stocks’ returns exceed the return of the Index.

The short answer is the S&P 500 Index with dividends reinvested earned 2.22 percentage points more than the high-dividend stocks every year. That’s a big difference.

Consider this example illustrating how much that difference matters: You have $1,000 you plan to invest for 20 years. If the last 10 years is like the next 20 years, then an investment in high-dividend stocks like these will grow to $10,397 while an investment in an index proxy like the SPDR S&P 500 ETF Trust (SPY) will grow to $15,120 (after SPY’s 0.0945% annual expense).

Now for single-period returns for the entire 10+-year period. The single-period return is the difference between the beginning and ending values:

• The S&P 500 Index single-period total return equals 293.93%.
• The mean high-dividend stock single-period total return equals 223.80%.

This only corroborates the mean returns. The S&P 500 Index’s nearly 300% return means its value nearly quadrupled during the ten years; the high-dividend stocks were about 70 percentage points behind for the entire period.

Investment Return Results: Dividends

If an investor had chosen the highest dividend-yielding stocks from this 35-stock sample, would they have earned a lower or higher total return than the entire sample? The correlation of dividend yields and total returns helps answer the question. Correlation measures the linear relationship between two variables. Correlation coefficients always assume values between +1.00 and -1.00, inclusive. A +1.00 correlation means the two variables covary perfectly. If the correlation is -1.00, they perfectly vary in opposite directions. A zero correlation means the variables have no relationship. An informal way of explaining correlation says large positive correlated variables tend to move in the same direction at the same time and large negative correlated variables tend to move in the opposite direction at the same time. It is important to note that correlation coefficients say nothing about causation; the coefficient speaks only to the association and is silent on whether one variable influences the value of the other variable.

• The correlation of high-dividend stock dividend yields and the mean returns of the high-dividend stocks equals +0.30.

The coefficient’s positive sign indicates higher returns are associated with higher dividends. But the coefficient is closer to zero than to +1.00. A statistical test of the coefficient’s value indicates it is not statistically different from zero. That is, the correlation is not strong enough to conclude any relationship between dividend yield and rate of return.

Investment return results, above, indicate the index of generally lower dividend (the Index) stocks earned higher returns than high-dividend stocks. The present result partly corroborates that result by revealing how dividend yield within the set of high-dividend stocks is irrelevant to total return. The highest dividend-payers in the sample would not have earned higher total returns.

Investment Risk Results: Return Volatility

The word “risk” often gets used as if it has the same meaning in all contexts. But there are different kinds of risks. For investors managing portfolios, the two main risk sources are volatility and insolvency or bankruptcy of a portfolio asset’s issuer. Investors handle these two risk forms in different ways, as explained in the “Allocation vs. Diversification” discussion, below. As for return volatility risk, the most widely used metric is the standard deviation. This statistic is also a mean, but it’s a mean of the dispersion of returns around the mean of returns. The greater the dispersion of returns, the greater the standard deviation and the greater the volatility risk.

• The S&P 500 Index daily standard deviation of returns equals 0.0109.
• The high-dividend stock daily standard deviation of mean returns equals 0.0077.

Index returns were 43% more volatile than the mean of high-dividend stock returns. However, none of the high-dividend stock return standard deviations is less than 0.0109! This outcome can be confusing. The quoted high-dividend stock standard deviation (0.0077) is calculated from the mean of the returns of all 35 stocks, not the mean of the 35 standard deviations. The mean of high-dividend returns produces a lower standard deviation because the mean smooths out the individual returns. Some returns are high, some low, and some negative. The mean of each day’s returns diminishes the effect of extreme returns. That leads to less dispersion of returns and a lower standard deviation.

Here’s the takeaway: If the last 10 years fairly represent the standard deviation of high-dividend stocks, then an investor holding a large number of high-dividend stocks like the stocks in this study would hold a less volatile portfolio than holding a portfolio that replicates performance of the S&P 500 Index. However, owning only a few high-dividend stocks probably would impose more volatility than an S&P 500 Index replicate because the low number of stocks would be insufficient to smooth out the extreme returns.

Investment Risk Results: Risk-Adjusted Returns

It’s one thing to compare returns. But risk goes together with returns. It’s better to compare risk-adjusted returns. Risk-adjusted return is the mean return divided by the standard deviation of returns. The best-known expression is the Sharpe Ratio, which includes a deduction in the numerator for the risk-free return (i.e., the return on short-term U.S. Treasury bills).

• The S&P 500 Index risk-adjusted return equals 5.51%.
• The high-dividend stock risk-adjusted return equals 6.46%.

Even though the mean return of high-dividend stocks is less than the mean return of the S&P 500 Index, the former’s lower risk renders a higher risk-adjusted return. However, only 2 of the 35 high-dividend stocks produced higher risk-adjusted returns than the Index. How can that be? Mean returns mollify the volatility and effectively mask the volatility of the individual stocks.

The takeaway here is the same as the takeaway in the comparison of standard deviations: Owning a portfolio of only a few high-dividend stocks would likely expose the owner to a lower risk-adjusted return than an S&P 500 Index replicate because it would impose more risk with a lower return. But owning a portfolio with many high-dividend stocks would probably produce a less volatile portfolio than an S&P 500 Index replicate and produce a higher risk-adjusted return.

Return Means and Return Distributions

On one hand, a mean of returns is a powerful statistic. A single number can represent hundreds or thousands of returns. How convenient! On the other hand, a mean of returns only quantifies a middle value, locating it among those other returns. Results from this study reveal how using only means to represent distributions could lead to disastrous results:

• Mean returns of high-dividend stocks suggest they impose less risk than the returns of S&P 500 Index stocks. But the mean returns only produce less risk because they mask extreme returns when the comparison involves a large number of high-dividend stocks.
• Mean risk-adjusted returns of high-dividend stocks suggest each unit of return requires less risk than each unit of S&P 500 Index returns. Spuriously lower high-dividend standard deviations might lead an investor to believe the mean applies to individual high-dividend stocks, but it does not.

All of this talk about risk leads to the methods investors use to manage risk.

Managing risk with high yield dividend stocks

Due Diligence

The first risk-management step, due diligence, is essential to security selection. It requires gathering and interpreting information about the potential benefits, risks, and costs of owning an asset. Volumes have been written on the subject. Unfortunately, the value of due diligence might have been misrepresented where it has been described as a way to outperform the market. There’s little compelling evidence to suggest investors can outperform the market. Moreover, look at any issue of Standard and Poor’s SPIVA Scorecard or its Persistence Scorecard. These publications reveal how even professional portfolio managers, mostly mutual fund managers, usually fail to match their benchmarks. When they do achieve superior performance, it usually fails to persist.

Due diligence does not usually lead to market outperformance. Rather, it helps investors avoid doing something stupid. For example, consider Exxon Mobil (XOM). It’s a company with a great history and a 9%+ dividend. But a quick look under the hood reveals a 200%+ payout ratio. The payout ratio is the dividend divided by net income. If payout equals 100%, then all income goes to shareholders. Anything greater than 100% means the issuer funds dividends with equity. A payout ratio greater than 100% cannot continue indefinitely without depleting the issuer’s equity. Maybe an XOM purchase would not be stupid; it might even be the next great recovery story. But if management decides to slash the dividend because trauma to the income statement persists, it will not look like a wise investment.

Allocation vs. Diversification

After deciding on suitable investments using due diligence, investors can manage risk with allocation and diversification. If you ask the average retail financial adviser the difference between allocation and diversification, they typically mumble a few things then come down to a conclusion like, “they’re basically the same.” This answer reveals the confusion academia and the retail investment industry have created.

It’s useful to distinguish the two. Allocation serves the “don’t put all your eggs in one basket” problem. Its first purpose (among a few others) is to help avoid the impact of an issuer’s bankruptcy or insolvency. Asset allocation is a process of distributing resources based mainly on nominal attributes of the investments. For example, the due diligence process might have led an investor to include in a portfolio high-dividend stocks along with U.S. growth stocks, stocks issued by corporations domiciled in emerging markets, stocks in developed non-U.S. markets, and debt instruments like investment-grade corporate bonds. Maybe the investor decides on a 60% allocation to stocks and a 40% allocation to debt.

Diversification builds on and modifies asset allocation. Whereas allocation is a nominal process, diversification allocates assets to capitalize on the reduction in volatility risk (not insolvency or bankruptcy) created when combining low-correlated assets. Diversification is less concerned with the number of assets or what they’re called and more concerned with their return properties, most importantly their correlation between portfolio assets and the risk they impose.

This is where a broadly allocated portfolio of high-dividend stocks can contribute most to a portfolio. The correlation of returns of the S&P 500 Index and the study’s high-dividend stocks is +0.67. Does that sound high? Look, retail investment advisers tell us we should “diversify” our portfolios by putting some of our investments in European and developed Asian markets. But the correlation between S&P 500 Index returns and returns of the iShares MSCI EAFE (EFA), an exchange-traded fund that replicates an index of non-U.S. developed markets, equals +0.88 for the 10 years in this study ending 17 September 2020. Also, EFA imposed 55% more risk than the mean returns of the study’s high-dividend stocks. If these relationships hold up, a broadly allocated portfolio of high-dividend stocks would contribute significantly more diversification to a large-cap domestic stock portfolio (like the S&P 500 Index) than a portfolio like investments in EFA. Continuing the example of constructing a 60-40-allocated portfolio, the correlations with large-cap stocks would lead the investor to devote less to EFA-like investments and more to domestic high-dividend stocks.

Backtest conclusion

High yield dividend stocks are unlikely to earn returns that beat the S&P 500 Index over a lifetime of investing. But the relatively low correlation with S&P 500 Index returns reveals their value in a well-diversified portfolio devoted to either growth or income. But to make the low-correlation benefit work, the high-dividend portfolio should consist of many individual stocks issued by corporations participating in many different industries so the portfolio mollifies extreme returns.

Now that we’ve looked at an example of a group of high yield dividend stocks and compared its performance to a broad market index, let’s look at some stock picking examples. For example, what if you just monitor some blue chip names and when their yields cross into attractive territory, you buy them? Let’s look at some common examples.

High dividend yield stock examples

Exxon Mobile (XOM): 10% yield as of September 2020

What about household name stocks that are currently paying extraordinarily high yields as a result of short-term factors? For example, as of late September 2020, Exxon Mobile (XOM) is paying a 10% dividend yield if you were to buy the stock today. Most investors correctly have concerns when a major, well-known company has a dividend yield this high. It usually means a dividend cut is coming. But can we quantify this further?

Between 2000 and 2018, Exxon’s dividend yield ranged between 2-4%. In early 2018, it went above 4% and it hasn’t looked back. Some investors might have been intrigued by a 4%+ dividend yield on a major company like this. After all, you could buy in, collect the higher-than-typical yield and hold the stock as perhaps the stock price rebounds. After all, Exxon did have yields above 4% in the 1990s for a time. Except the picture has worsened dramatically since then. How bad? Let’s look.

If you purchased XOM stock around $75 at the beginning of February in 2018, you’re now holding a stock that has been cut in half at right around $35 per share. Yes, you would have collected about $9 via the XOM dividend per share since that purchase. So instead of being down 53%, you’re only down 41%. That’s really bad.

It’s even worse when you compare it to the S&P 500.

But sure, the energy sector has been decimated. So perhaps we should consider high yield dividend stocks that cross above a certain yield threshold in other sectors.

AT&T (T): 6% yield after 2008 market crash

After the significant drop in the market and stock, you could have purchased AT&T stock on October 1, 2008 at right around $26.77. The reason this is notable is because it took the stock above a 6% yield for the first time in years (it briefly touched just over 6% in 2003, but was mostly in the 4-6% range in previous years). So, perhaps you had a mind to buy the telecom giant as a result of an advantageous high dividend yield to lock in. It certainly could have been a justifiable move. After all, the market crash in 2008 was mostly centered around housing and the financial sector, and wireless communication was only going to keep growing. Getting a defensive name during a period of market turmoil and get paid 6% to hold it could seem quite logical.

Amazingly, once again, the better move would have just been to buy the S&P 500. By a lot.

Without considering the dividends, here’s the difference in stock performance when comparing buying AT&T (T) in early October 2008 or just buying the S&P 500.

Pretty remarkable difference no? What about when factoring in the dividends? Even with that healthy yield, you’re still underperforming by a wide margin. If you held from October 2008 until September 2020, you’d have collected just over $22 in dividends per share. As of writing, the stock is right around $28, so the stock is just barely above flat performance over 12 years of holding it. Adding in the dividends, you get close to doubling your money. But the S&P nearly tripled during this time, and that doesn’t even factor in the dividends collected by holding the S&P which is not trivial.

Johnson & Johnson (JNJ): 3% yield after 2008 market crash

Let’s look at one more example and this one comes from the health care / pharmaceutical sector. After the market crash of 2008, JNJ’s dividend yield went over 3%. Prior to that, it was below 3% going back to the 1990s and even below 2% for many of those years. Perhaps the rise in yield caused you to buy the stock at this point which would have indeed been a good buying opportunity. But how did it perform against the broader market? We’ll use the starting point of Nov 1, 2008 for our comparison.

Once again, looking at stock price the S&P 500 beat JNJ handily over the last 12 years.

A single share of JNJ purchased for $58.58 back in 2008 is now trading for approximately $147 and you would have collected $34 in dividends along the way. The total return is good for essentially tripling your money.

However, if you purchased the S&P 500 index ETF (SPY) for right around $90 a share back in November 2008, you would have collected $47 in dividends and be holding a share of SPY at $332. Total it up and you more than quadrupled your money.

The ultimate question: Find high yield dividend stocks or just buy the S&P 500?

If you put everything we’ve discussed together, I believe it undoubtedly leads to one conclusion. Stocking picking – whether it is stock picking with an emphasis on dividend stocks or not – is tough and rarely outperforms the broader market index. Now, to be fair, there are a few factors at play in the last decade or so that has indeed made this trend even more pronounced:

1. The broad market index has been killing it since the 2008/2009 stock market crash. Other than the coronavirus crash of March 2020, simply buying the S&P 500 index has essentially beat every other strategy out there. So, in one sense, of course dividend stocks have lagged the S&P 500.
2. Tech stocks have been leading the way especially recently. Mega cap technology stocks such as Apple, Amazon, Microsoft, Google, Facebook, etc. have been leading the market high especially in 2020. While some of these stocks pay dividends, they aren’t exactly known has high dividend paying stocks and many of them pay no dividend at all. It’s not only tech. Growth in general has been slaughtering “value” now for some time. Again, this has led to underperformance in value stocks, many of which find themselves on the lists for high dividend stocks.

So, what to do? How should we invest? Rather than frame it as an either-or, it could make sense to consider it as a both approach. Consider the following investing principles that might guide our decisions:

1. Just because value stocks have been trounced for some time, it doesn’t mean this lasts forever. At some point, investors might rotate out of high-flying growth stocks back into more conservative and defensive stocks with more attractive yields.
2. Dividend paying stocks can offer less volatility and while they might underperform the broad index in raw returns, the risk-adjusted returns can be attractive. Risk is the part of the investing equation often ignored, but as we showed above in the backtest example, muted volatility can lead to higher risk-adjusted returns. Perhaps the majority of your portfolio is in index funds, but you slice off a chunk of the portfolio and put in a basket of high yield dividend stocks. The goal here isn’t to design a portfolio that’s going to beat the market. The goal is to design a portfolio that offers very good returns, but also a little less volatility than the broad stock market.
3. One of the reasons to own the index is because we don’t know where leadership will come from. Recently tech stocks can do no wrong. But in the mid-2000s, Exxon Mobile (XOM) alongside a sky-high oil price was the largest stock in the S&P 500. While Apple might be the most valuable company today, there will be a point in time where it no longer leads to market. We don’t know what will lead next just like we didn’t know that Exxon would fall and tech stocks like Apple take over. But by owning the index, you can be assured that you’ll own whatever leads next. While some components within the index will underperform and fall, others will rise and outperform.
4. Perhaps consider a slice of high yield dividend paying stocks similar to how you consider bonds. Again, if the bulk of your allocation is in index funds, you might use dividend stocks to bolster your portfolio similar to how bonds are used. Bonds and defensive dividend stocks can provide ballast for your portfolio during market turmoil.

Frequently Asked Questions

What are the best dividend stocks?

The best dividend stocks don’t necessarily always mean the highest yields. The best dividend stocks are companies with long track records of steadily increasing its dividend payout while maintaining a comfortable payout ratio (where its free cash flow easily covers its dividend payouts). Red flags are when high yielding companies have increasing levels of debt and a lack of top line revenue growth which might indicate they are using debt to pay its dividends.

What are the safest high dividend stocks?

The safest dividend stocks are typically in that range of 1-4% dividend yield with companies that have little or no debt, a healthy coverage ratio with free cash flow that easily covers its dividend payments and growing revenue year after year. A combination of increasing debt or declining revenue and cash flow can often lead to dividend cuts.

Are high dividend stocks safe?

Typically dividend stocks with outrageously high dividend yields are not safe and often have these dividends cut. These companies are often companies with declining businesses that can no longer maintain the dividend payments due to rising debt levels and/or declining cash flows. Often times, the share prices will reflect this business reality before the dividend is cut which can lead to unusually high dividend yields for a period of time.