What drives stock returns?

What drives stock returns?

With so much negativity towards dividends and dividend investors, in some circles, I thought it would be important to summarize some academic research as it relates to the drivers behind stock returns. 

Then, and only then, you can be your own judge if dividend investing might matter to you, or not!

Expected stock returns from factors

Simply put, higher expected returns may require taking on additional investment risk.

This is the stomach required for the DIY investor to navigate. 

Not only do you need to take on higher equity exposure for higher long-term portfolio returns, DIY investors must also consider other factors to help deliver higher their returns, all the while avoiding any major self-inflicted wounds related to stock trading or market timing. 

Most academic papers I’ve found or read about for the last 75 years or so have referenced these three premium investing factors that should deliver higher (expected) returns: 

  1. The equity premium (common stocks (equities) have returned more than bonds (fixed income) over time.)
  2. The small-cap premium (smaller-cap stocks (given the potential to grow substantially) have returned more than larger-cap stocks over time.)
  3. The value premium (value companies have advantages over growth companies since they have more predictable metrics vs. growth companies, more predictable earnings, sales, and/or cash flow so you should have greater risk-adjusted returns from value stocks over owning growth stocks.)

A quick Google search with any of these terms above in bold will yield much more information than any one blogpost could ever cover….

As a student of market history, to some degree at least, this resonates with me and knowing this has been used as inputs to shape how I DIY invest. More on that later… 

Professors Eugene F. Fama and Kenneth R. French have been pioneers in factor-based investing work.

In 1992, professors Eugene Fama and Kenneth French published an impressive paper called “The Cross-Section of Expected Stock Returns.” Given this is Nobel Prize-esque work (Fama won a Nobel Prize in Economics in 2013), I’ll leave it to you to read the paper and interpret it clearly!

The Fama-French Three Factor Model is pretty complicated stuff but in a summary it calculates an investment’s likely rate of return based on the three elements I referenced above: overall market risk, the degree to which small companies tend to outperform large companies, and includes the degree to which high-value companies tend to outperform low-value companies.

Here is a good “shorthand version” of the Three Factor Model: 

  • Return = Rf + Ri + SMB + HML


  • Return is the rate of return on your portfolio or investment being measured
  • Rf is the risk-free rate, the rate of return given by a zero-risk asset such as a Treasury bond or bill (U.S. and not Canadian references)
  • Ri is the market risk premium, the rate at which investing in the market at large outperforms investing in a zero-risk asset
  • SMB (or Small Minus Big) is the performance of small-cap companies vs. large-cap companies
  • HML (or High Minus Low) is the performance of high book-to-market (or “value”) stocks vs. low book-to-market (or “growth”) stocks


Many years later, Fama-French published “A five-factor asset pricing model” in the Journal of Financial Economics as an upgrade per se.

The Five Factor Model included additional factors:

4. Profitability (the operating profitability of a company – it should be little surprise to many dividend growth investors that profitable companies tend to perform better over time.)

5. Investment (includes the concept of internal investments and expected returns; companies directing profit towards major growth projects are likely to experience losses in the stock market.)

These latter two factors may be considered more “quality” factors over the Three Factor Model. 

Over the years, the economics academic community has continued to study other factors as well, like momentum. For momentum, stocks tend to maintain recent price trends in the future, and the momentum investing or strategy that includes momentum takes advantage of this phenomenon. There is of course a downside to this as well: substantial corrections and market reversals can and do occur!

Here is an interesting fact sheet on momentum from MSCI.

Beyond three factors or five factors and even more like low volatility in particular, if there are literally dozens of factors that could be considered to help determine higher expected returns, how do we know which ones to follow or not and what does this have to do with your investing approach?

Behaviours matter

Behavioral finance has emerged as a major discipline over the last 40 years or so that examines the deep psychological and sociological factors that affect financial decisions.

Because is it simply impossible for any individual investor to always act rationally, we need to account for some errors from time to time as part of any financial decision we make – we simply don’t want to make big financial mistakes!

From a behavioral finance perspective, investors like you and me are not only influenced by economic and financial indicators when making our decisions, we have the biases of past experiences, personal situations at the time, investment preferences; our gut-checks, and we lean on our body of knowledge too. Although a challenge, most of us as long-term investors by now know our risk tolerance or at least something close to it. That degree of risk perception or our personal risk appetite will vary from what someone else feels – which is not right or wrong – it just what is.

Risk IMO can therefore be framed as an unknown future and the impacts of making any investment decision today that works out poorly or in favour for us. We need to make our best guess today for a future that is wildly uncertain. 

Dividends matter (or do they)?!

Most investors know from reading my blog for years on end, that I have a hybrid approach to investing:

  1. I invest in dividend paying stocks for income and growth, and
  2. I invest in a few low-cost ETFs to invest beyond Canadian borders for extra diversification. 

Most investors will also know that eligible dividends from Canadian companies are taxed at a much lower rate than interest and foreign dividends, in a taxable account.

In fact, for each Canadian in pretty much any province or territory who makes less than $50,000 or so, the tax rate on dividends is actually negative per person!

But remember, the Canadian Dividend Tax Credit is only a benefit for taxable investing.

Tax treatment of Canadian dividend paying stocks

Dividends v. Capital Gains – what should you favour?

Regardless of the accounts you own, registered and/or non-registered or both, recall that stock returns generally come from two sources: dividends and price appreciation/capital gains.

I see these things as two sides of the same investing coin: dividends and capital gains are great but you can’t always hope for lots of both – so you generally need to side with one or the other. 

Or do you?

The large-cap Canadian stock market is generally speaking, very dividend friendly and has delivered great long-term capital gains too. Many Canadian large-cap stocks have been paying dividends for generations and as long as they stay in business of course, and earn higher profits, they are likely to continue doing just that. 

Here are a few examples of some companies that have performed very well in my portfolio.

Railroads (CNR and CP):

Economic Moats - CNR and CP March 2023

Waste Connections (WCN) stock:

Economic Moats - WCN March 2023

I have many other examples as well.

Of course, not everything is a rose.

I have owned companies that have cut their dividend from time-to-time. I don’t shy away from that and very honest about that. Such is the risk of individual stock selection. I take the good and the not-so-good. 

Generally though, over a long investing period, my research and my personal experience shows income investing in Canada can work very well for these underlying reasons, owning a basket of stocks:

  1. Canadian large-cap stocks have dividend-friendly policies with price appreciation, 
  2. The Canadian market operates in an oligopoly in many ways (you can easily identify large players and few of them in many industries), and behaviourally,
  3. The tangible income I receive today from larger-cap Canadian companies reinforces my investing behaviour moving forward such that:
  • I maintain investing discipline – to stay the investing course in such companies, with very few trades or sales over time. 
  • I continue to be inspired – seeing income flow into my account, investing more money when I can. 
  • I remain motivated – by sticking to my DIY plan I tend keep other greedy financial piranhas away from our money. I’m not paying for someone else’s yacht.

Weekend Reading - Top travel tips edition

Taken on my trip to Fort Lauderdale. This may or may not be owned by a money manager! 🙂

Many Boomer investors, and myself as a GenX investor, have Tom Connolly to thank for trailblazing DIY investing in Canada since the early 1980s. 

Income investing is nothing really new.

Some quotes from Tom:

“Do not consult a wealth manager. Wealth managers are a class of middle-person unknown our forefathers. Their only source of wealth is other people’s money. They have no skin in your game. Invest directly in businesses yourself.”

“How many stocks? (Dec 2020) John Maynard Keynes said “A careful selection of a few investments . . .” . In contrast, VEQT, the big Vanguard ETF, has 12,532 stocks. Which would you rather hold, a few quality companies or thousands of mediocre stocks? Do thousands of stocks make things safer? Most of the companies in the Connolly Report list doubled their income in the last decade. Does your retirement income double every ten years? It’s the cash flow that counts.”

This approach is something I latched onto almost 15 years ago: investing in a way that delivers rising cashflow from my portfolio without selling assets in my portfolio, matters to me. 

Am I giving up stock returns with my DIY approach?

Not in Canada, not yet at least. 

By skimming the index over the years, using low-cost ETFs like XIU, VDY and others as proxies to make some of these stock selections made easy, I’ve exceeded my benchmark index but that’s not really my point let alone my goal.

While I’ve embraced the equity bias in my portfolio via owning larger-cap Canadian stocks I confess/fully admit I don’t own any small-cap stocks so I’m not taking advantage of that small vs. big premium per se. I could be missing out.

Potentially as a dividend investor I have however already designed-in the value premium since I don’t own many growth stocks in Canada; I prefer owning companies that have growing earnings, growing cash flows, etc. and those companies can reward shareholders via an increasing dividend payment as just one way to deliver shareholder returns. 

Beyond Canada however, I gravitate to owning low-cost ETFs beyond a few U.S. stocks. That approach provides extra diversification in my portfolio, albeit less distribution income for today. To be honest, less returns too. In the last few years, my DIY Canadian stock portfolio has hammered the returns of low-cost ETF XAW and VXC as an example. That trend may reverse, eventually. 

What drives stock returns summary

Equity investors who are building their portfolios in taxable accounts should think carefully about whether they really should focus on Canadian dividends. Meaning, if you’re in a high tax bracket, it might make sense to look at Canadian equities that pay less in dividends and deliver most of their returns in the form of price appreciation. That I agree with. That’s part of my taxable portfolio construction anyhow with some of those stocks I featured above. Your mileage may vary. 

But the facts are, in any account, while dividend-paying stocks and dividends unto themselves may be technically irrelevant due to the academics associated with where returns really come from, in asset pricing models, the income earned from our collection of stocks we own is very real money, that very real money continues to grow, and that very real money continues to reinforce my overall financial behvaviour.

With that behaviour, I am/we are realizing our financial goals. 

Keep Investing Super Simple - Goals and Happiness

Source: Behavior Gap, Carl Richards.

Dividends and distributions earned from an income-oriented approach continue to support my investing discipline, they keep me engaged and inspired to invest, and they motivate me to continually learn more over time.

There is a wealth of academic research beyond this simple post about what factors drive higher expected returns.

Simply put, expected returns = current market prices + expected future cash flows.

Whether or not you like dividends, you can use that equation to define your investment plan accordingly.

Should you really prefer dividends?

In closing, maybe you should not.

As perfectly rational investors, we would all own stocks, thousands of them, in absence of whether or not they pay a dividend. That’s precisely the mantra from index investors. 

If you want to index invest in Canada, in the U.S. or around the world – go for it!

Based on my personal experiences with Canadian stocks and our income goals, I know what I favour. 

I look forward to your comments and insights, as always, even when they differ! 


My name is Mark Seed - the founder, editor and owner of My Own Advisor. As my own DIY financial advisor, I'm looking to start semi-retirement soon, sooner than most. Find out how, what I did, and what you can learn to tailor your own financial independence path. Join the newsletter read by thousands each day, always FREE.

8 Responses to "What drives stock returns?"

  1. In the following comments do you not mean “unlikely” to experience loses in the stock market?

    5. Investment (includes the concept of internal investments and expected returns; companies directing profit towards major growth projects are likely to experience losses in the stock market.)

    1. Nice to hear from you, Susan!

      No, 5. is correct. A few references:




      The thinking is, companies that are diverting their funds to projects, committed to growth/committed to projects they cannot easily get out of, may struggle when it comes to expected higher returns.

      Somewhat counterintuitive!

      I hope all is well!

        1. I think it all depends and I recall this is about predicting higher, expected returns, not that it can or will happen for certain.

          I think the model works in that companies that invest, somewhat conservatively, have higher returns vs. companies that invest too aggressively.

          Finally, for me, the biggest factor in this model seems to be operating profitability. Meaning, a company that has high, ongoing profitability tends to have higher returns over unprofitable companies. Makes sense, as it aligns to dividend payers. You can’t fake profits or dividends for very long.

          Thoughts? How are your investments coming along? 🙂

          1. That is why I am into dividend paying stocks. You cannot fake dividends for very long. Hopefully, anyways.

            My dividend accounts, where I get my income from are doing just fine. The portfolio value goes up and down, of course, but my dividend income always goes up.

            I have been fooling around with small Canadian companies, and I am using my TFSA account for this. Lately I have been in to such stocks as Neighbourly Pharmacy Inc (TSX-NBLY) and I am having some fun.

  2. Hi Mark

    Have I got this right?

    In ETF’s, I use XDIV as part of my non-registered portfolio. I like the Canadian Dividend Tax treatment. I use the dividends as part of my annual income plan (retired) and it contributed to the a “Yield Shield” effect in volatile markets.
    As I am filing my taxes much to my disappointment this ETF in 2022 spun off close to 10% in unrealized Capital Gains in 2022. My understanding is that this unrealized capital gain on my T Slip is due to internal churn of holdings in the fund?

    I “tune” my income to produce low taxes, so this unexpected and unrealized “gain” cost me an extra Grand in taxes….

    So this year I will switch out to a more individual Canadian Dividend equity approach, maybe BTTSX.

    What do you think of the Horizons approach of say HXH, where Dividends just get added in, no tax impact until you sell for income with Capital Gains?
    Gives you total control, substituting Dividend Tax Credit for the 50% Capital Gains.

    1. Hi BK,

      That’s the challenge with some ETFs, there can be unrealized gains during the year. XIU in Canada tends to be one of the more efficient ETFs for taxable investing. Very few if any capital gains when you look at the distributions page.

      ETFs may earn dividends and interest income from the securities they own, and they may realize capital gains or losses when investments are sold – that’s essentially it.

      I like BTSX stocks and have owned many, for many years, vs. buying new ones every year so I’m not really following the approach per se. More buy and hold and buy some more guy here 🙂

      Big fan of Horizons HXS, HXT if you do not intend to sell those ETF units very often. I interviewed the VP a while back here:

      Hope that helps!


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