Gen Z is obsessed with dividends. But at what cost?

There’s a hot new Gen Z investing trend, and it’s all about dividends. With its own ecosystem of finfluencers on Youtube like Dividendology and a dividend investing subreddit with 911,000 followers, the trend is sometimes called dividend maxxing, yield maxxing or my personal favourite, “dividends and chill.”

Here’s how it works: You buy stocks or exchange-traded funds (ETFs) that pay dividends, collect those dividends as passive income and reinvest those dividends so your holdings grow over time. Once your passive income replaces your expenses, you retire.

So, what is the problem here? Isn’t that the model that the Financial Independence, Retire Early (FIRE) movement follows?

In many ways, yes. Investing your money in passive-income producing investments and using that to retire is a core principle of the FIRE movement. The big difference is that this approach heavily favours dividends, while FIRE is more agnostic: interest, dividends and capital gains all count.

This is reflected in the different ETFs we use. The FIRE movement uses low-cost index funds like Vanguard’s US Total Stock Market ETF (VTI) or iShares Core S&P/TSX Capped Composite Index ETF (XIC) to build our portfolios, while dividend investors often use the Schwab US Dividend Equity ETF (SCHD).

More portfolios for value and dividend investors to consider

Because these investors want steady dividends, this strategy tends to concentrate on large, stable companies like banks, health care and consumer staples. This underweights growth sectors like the tech sector, which reduces volatility but means they miss out on the sectors’ long-term capital gains.

Dividend investing is a perfectly reasonable strategy that has existed long before Gen Z discovered it. Where it starts to get alarming, however, is when investors get impatient.

The SCHD fund currently has a dividend yield of 3 per cent, which is miles better than VTI’s yield of just 1 per cent. But it also means that if you need $60,000 to retire, you would need approximately $2,000,000 worth of SCHD to retire on it.

What if you wanted to retire on a smaller portfolio? The FIRE approach would be to reduce your living expenses. If you want to retire with half as much money, you need to spend half as much per year. In other words, FIRE advocates for changing your lifestyle – not your investments.

Dividend maxxers do the opposite. Rather than cut costs, they search for funds paying higher yields. After all, if your investments were yielding 6 per cent rather than 3 per cent, you would only need $1-million. If your investments were yielding 12 per cent, you would only need $500,000.

That math is seductive, and that’s when this strategy becomes dangerous.

Dividend stocks are getting dinged by rising bond yields. Just look at Fortis. And Telus. And TC Energy …

The perceived safety of dividend investing is that you don’t have to sell any shares to fund your living expenses. You simply buy, hold and live off the dividends. But yield is not the same as dividends. Just because a fund advertises a certain yield every month doesn’t mean it’s sustainable.

Covered-call ETFs are one example.

They are popular among dividend investors because they advertise a much higher yield, but most of that yield is not being funded by dividends. Instead, the funds use a strategy involving call options, which creates income from a basket of stocks by collecting option premiums and redistributing them to fund investors. But it works best when the stock market is relatively flat or rising modestly. When the market spikes higher, these call options can work against you because the fund can be forced to sell off shares if those options get called.

That’s not a passive buy-and-hold strategy, although it feels like it because the fund holder is sitting there and collecting their monthly payments. But underneath the hood, someone is actively trading on your behalf.

Let’s look at the long-term performance of three funds. An index fund like VTI yields about 1 per cent, a dividend index fund like SCHD yields 3 per cent, and a covered-call ETF covering the S&P 500, such as JEPI, yields almost 8 per cent.

Someone chasing dividends would be highly tempted to pick JEPI because a nearly 8-per-cent yield is better than 3 per cent or 1 per cent. But let’s look at how these funds performed over the past five years if an investor reinvested all dividends produced.

As you can see, that yield isn’t free. The higher current income you want, the lower the long-term performance of that fund tend to be.

There’s a lot to like about dividend investing, and the idea of living off your dividends while never touching the principal sounds great. But every investing decision comes with trade-offs, and it’s important to understand them.

Kristy Shen and Bryce Leung retired in their 30s and are authors of the book Parent Like a Millionaire (Without Being One).