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Lars Kroijer on…dividend stocks, emerging and small cap trackers, and cash

I am super happy to welcome back Lars Kroijer for another investing Q&A. This is a collaboration between Monevator and Lars’ own YouTube channel [1].

All the questions below come from Monevator readers. As [2] before [2], Lars’ answers in both video and edited transcripts.

Note: embedded videos are not always displayed by email browsers. If you’re a Monevator email subscriber and you can’t see three videos below, please head to our website to view this Q&A with Lars Kroijer.

What’s the case against dividend stocks?

We start this time with a question from Ray. He is in the de-accumulation phase, but he’s still looking for a return on his investments.

Ray notes that Lars tends to recommend global equity market [3] trackers. However, Ray continues, “this year, the ACWI – the All Country World Index – is only paying a 1.7% dividend, whereas my dividend-focused ETFs seem to be doing better than that. So is my strategy wrong?”

Lars replies:

So here we’re in the world of equities. I have explained elsewhere why most people should not have just equities in their portfolio. It is typically far too risky. Please see my other work for more on that [4].

It’s also worth noting that I argue you can’t outperform the markets. You should simply buy equities in proportion to their market value and diversify across the total world market as much as you possibly can, and as cheaply as you can. We do that is because we don’t think we can allocate value between equities in a superior way to the market. We accept that we cannot beat the market.

On to this question about dividends.

The first thing to ask: is there any reason to think that dividend paying stocks overall will outperform non-dividend paying stocks? And the answer to that is, no – unless you think you can beat the markets.

With dividend-paying stocks, you get a change in the share price – capital appreciation – plus the dividend. Whereas with non-dividend paying stocks, you just get that change in the share price.

Now I think what Ray is alluding to – and practically speaking, I can see an argument for – is automatically receiving dividends into your bank account. You need the cash, perhaps for your living expenses. If you have non-dividend paying stocks, you have to sell securities to realize your capital to get that cash. That can be a headache for some people.

I think the overriding issue is one of tax.

Suppose we have two groups of stocks. One pays a 5% annual dividend and the other does not pay a dividend.

Let us say the first group is flat for the year. But you received your 5% dividend, so your $100 became $100 plus $5 as a dividend.

With the second group you do not receive any dividend. However those shares went up by $5. So they are now worth $105.

This could be a similar group of stocks. It could even be index trackers with different payout policies, which may be what Ray is alluding to.

Anyway, with the second group, to obtain the cash you would have gotten from your dividends with the first group, you can sell 5% of your portfolio. You should – ignoring tax – be equally well-off.

For most people, in one case you would be paying a dividend tax and in the other a capital gains tax. That choice is what should drive your decision. It’s not that we think we can predict which group of stocks will do better. It’s more that your individual tax situation should drive it.

Also note some trackers pay out the dividends they receive from the underlying companies. Others reinvest it. Again, which type [5] you own should depend on your current and expected future tax situation.

That should be the driver, not the dividend policies of the underlying businesses.

Beyond a global tracker for equities

Next up is ‘MBA’, who asks: “Does your case for using a global tracker fund mean one should not invest in a global smaller company tracker? At the moment, my split is 60% global all caps, 20% global smaller companies, and 20% emerging markets.”

Over to Lars:

Let me start by emphasizing that I believe you should really try – with the equity portion of your portfolio – to own equities in proportion to their market values.

Of course most people should not only own equities. There are other videos I’ve done on how you should think about your split between different asset classes. Equities-only would be too risky for most people.

Ideally, you should invest in equities according to their market value. You are essentially saying each dollar invested in equities is equally clever and well-informed. You don’t think you can do better by allocating the proportions of your stocks in a different way from what the market has already done.

You say this because you accept you cannot outperform the markets. You’re simply trying to capture the global equity risk premium [6]. What this is is anyone’s guess! But historically, equities have outperformed the risk-free rate by about 4-5% above inflation.

I am saying you should invest in all equities to capture this premium.

But in reality, as MBA suggests, a lot of the indices do not really include small caps. Small caps may be too expensive or illiquid to trade. It’s therefore hard to represent them perfectly, all over the world. So very often they’re excluded – certainly in the larger indices.

Likewise, a lot of indices have a heavier weighting to the US market compared to its share of GDP, or to global equity values. There are various reasons for this. One is there is a disproportionate number of huge global companies quoted in the US. Think Google, Facebook, Apple, and so on. These are all large global firms, with a lot of business outside the US. The stocks are bought on the US market. But that does not mean you’re only exposed to the US economy with them.

In any case I don’t really have a problem as to what MBA suggests with people that say “I kind of want to correct this lack of exposure to small caps” or “I kind of want to get a little bit away from what some perceive as an overexposure to the US stock markets”. You might do that by buying small cap index funds. Just be sure you do it in a globally diversified way.

Make sure you do not end up with a portfolio where you essentially become a collector of indices. You can have so many indices tracked that you don’t quite know what is there or why.

A lot of global indices are highly-correlated. I think you get 95% of the way there by owning a global tracker.

Holding cash instead of government bonds

Our last question comes from ‘Haphazard’, who asks, “Do you still believe the lowest-risk part of a portfolio should be in a government bond fund? Even with today’s very low negative yields – as opposed to cash, for example?”

Lars replies:

First, a reminder. I believe that for a large majority of investors, you can create a very robust portfolio with two products. You select the lowest risk government bond in your currency and at the appropriate maturity, and you combine that with a global equity index tracker. You choose the proportion to suit your individual risk preferences.

Check out my previous video series [7] on Monevator for more on that.

Coming back to Haphazard’s question, I don’t have a problem with cash. I would just encourage you to think of the risk of the bank where you have your cash, versus the risk of a local government bond.

For most developed economies, there is a deposit insurance. The government guarantees deposits and banks up to a certain amount.

That means for up to that amount you’re effectively taking government risk.

As a side note, this means if you have your money with one of the larger banks in your country, there is a high correlation between the failure of that bank and the failure of your government. I know that in a lot of the economies around the world that may seem remote in early 2021, but it is something to think about.

I would also say be careful about going yield hunting among other country’s government bonds. You would be taking FX risk in a lot of cases. Also, if you’re getting a higher yield you’ll typically be taking some credit risk. The higher yield alone does not tell the whole story.

Most people would intuitively understand the very high interest rates you’re getting from governments like that of Venezuela do not make much sense. You’re taking massive FX risk and credit risk. People would therefore stay away. But even in less extreme samples, you’re taking FX risk and credit risk if you are getting a higher yield.

Coming back to cash – and maybe cash alternatives – with your local bank. As long as it is within the insurance limits, then absolutely take it if you’re getting higher yields.

However if you’re buying your local bank’s fixed income products and they’re giving you a far higher return than your local government bond – and you aren’t within the deposit insurance – I’d encourage you to understand what kind of risk you are taking.

Are you well-equipped to take that risk?

For example, you might make higher returns with corporate bonds than your government’s bonds. But you’re also taking a different and in some cases a far higher risk that you may not be very well-equipped to take.

I also worry a bit when people say interest rates are so low they cannot possibly go any lower. Predicting interest rates is like predicting stock markets. It’s very hard for individual investors to do better than the market.

I’d encourage you to really think about what it is you believe you know that enables you to do that.

If you feel the minimal-risk asset’s interest rate does not give you enough return in your simple two-product portfolio – and you’re willing to take more risk – I’d say maybe take that risk in the equity markets. At least that keeps things simple.

The lowest risk part of your portfolio is not a return generator. It is the part where you say you’re not going to lose this money, come what may. So perhaps try not to be greedy!

Until next time

Please do follow-up Lars’ answers in the comments below. You can also ask us questions for next time, although we’ll only be able to pick three of them.

Watch more videos in this series [2]. You can also check out Lars’ previous Monevator pieces [8] and his book, Investing Demystified [9].