Do you like receiving dividends? Of course you do. Everyone likes receiving checks in the mail.

People often tell us that they need their dividends to live on. That they don't want to dip into their capital. The problem is that by aiming at stocks with higher dividends you may actually be destroying your capital at an even faster rate.

It is true. By not selling your shares you may not actually be dipping into your capital. But the overall effect on your capital may be even worse.

When considering capital gains versus dividends it is important to remember that money is money. They don't ask you at the checkout counter at the supermarket whether the money came form capital gains or dividends.

The terminology in this area is that dividend yield is the ratio of dividends to the price of the stock. Sort of like the rate on bonds except with the share price instead of the face value of the bond. Even though there are variations within each sector, each sector tends to have its own general level. 

Most years the sector with the highest average dividend yield is Electric Utilities. The current average dividend yield is around 6 percent. The sector with the lowest dividend yields is usually Application Software. Most of these companies pay little or no dividends.

Let us consider two investors, Jack and Mary, brother and sister. Jack remembers hearing his father say over and over not to sell shares. "They are your capital," he would say. "And you have to preserve your capital at all cost."

With this idea drummed into him, back in 1998 he came across Duke Energy. For the previous 5 years it had paid an annual dividend of around $1.00 with $1.08 in the previous year. This has meant an average dividend yield of between 3 and 5 percent. 

At the start of 1998 the price was $27. Suppose you bought 1000 shares for a total of $27,000. Each year since then Duke paid a dividend of $1.10. So each year Jack received a total dividend of  $1,100 per year towards his living expenses.

When you started back in 1998 this was a dividend yield of 1.10 / 27 = 4%. Not bad, you are thinking. A certain payment of each year at an initial rate of 4%.

The problem is that although Duke hit a high of $47 a few years later, since then the price has crashed to around $20.

This means that although you have received your $1,100 each year, and although you still have the 1000 shares you started with, your net worth has dived from $27,000 to $20,000. Currently the dividend yield is 6 percent.

In contrast, Mary remembers her mother always saying that "money was money. Make the best investments you can. When you have to pay your bills, pay it with money that is the 'cheapest' and will have least effect on your future finances."

Mary also had $27,000 to invest back in 1998. She had been shopping at Bed Bath and Beyond (BBBY) for the last ten years and liked what she saw. She talked to a few of the people at the store. She also contacted the company and found that it was expanding across the USA.

So Mary decided to invest her $27,000 in Bed Bath and Beyond.

Jack also did some research on the company. He discovered that it did not pay any dividends and was not likely to pay any in the foreseeable future.

When he confronted Mary with this news, she replied that she already knew that. "But I am still going to invest in it," she told him.

"Well don't come to me when you need money to live on," he flung at her as he left.

At the start of 1998 the price of BBBY was $9.90 so she bought 2,727 shares. At the end of the year the price was $16.00 so she sold 68 shares to get $1,100 in cash, the same amount that Jack had got from his dividends. This left her with 2659 shares.

At the end of 1999 the share price was $13.60 so she sold another 80 shares to get another $1,100 in cash. This left 2,579 shares.

Repeating this each year left Mary with 2,475 of her original 2,727 shares at the start of 2003. Here is the table of Mary's transations.

Jack accused Mary of dipping into her capital each year and forecasting a dire outcome because the number of shares she owned had dropped by over 250.

But Mary was not worried. She saw that her wealth had grown from $27,000 to over $80,000.

The moral here is don't confuse a decreasing number of shares with decreasing wealth. Even if the numbers go down because you need money to live on, your total wealth may well be going up.

Also, always make the best investment you can in terms of total return meaning capital gains plus dividends. And don't panic if you have to sell some shares to live on.

You might think that I picked unfair examples here and that, on average, it is better to choose stocks with higher dividend yields. In that way, you could argue, you are at least increasing the chances of getting a higher total return.

Well even that is not true. Over the past year, looking at the largest 1,500 USA stocks, approximately half did not pay dividends and a half did. The average total return of companies that did not pay dividends was 5.43 percent. In contrast, the average total return of companies that did pay dividends was -0.98 percent. The money received from the dividends was outweighed by the loss in capital.

Even within the companies that did pay dividends, there was no correlation between their dividend yield and their total return. In other words, a higher dividend yield was no guide to a higher total return.

In Australia, things are much the same, even though a slightly higher proportion of companies pay dividends (55 percent compared to 50 percent). Of the 350 companies that I studied, those not paying dividends out performed the dividend-paying stocks by around 5.5 percent (27.29 percent compared to 21.67 percent ).

Furthermore, there was actually a slightly negative correlation between dividend yield and total return for those stocks that did pay dividends. This means that a higher dividend yield actually indicated, on average, a lower total return.

Two final points, transaction costs and taxes. It used to be that you paid an extra fee to buy or sell unusual numbers of shares. Odd lots they were referred to. This is rarely the case now and does not occur with on-line broking where transactions fees are very small. Regarding taxes, there are differences in the way capital gains and dividends are treated in both the USA and Australia. I will talk about these differences in a later article.

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