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The Pitfalls of Dividend-focused Investing

There are a number of investors that have the belief that an investment strategy focused on dividends is preferable when income is desired.  Understandably, it's enjoyable to see a cash flow come in from your portfolio, but research going back as far as 1961 shows that dividends are immaterial, irrelevant and even harmful to the design of a well-diversified portfolio.  Here are a number of thought points for your consideration, and at the end of the article are three articles that go into further depth on these topics and more.

$100 minus $1 is always $99

Dividends are, at their core, simply a restatement of capital into earnings.  From a corporate level, when a company pays a dividend to their shareholders, that cash is now off the books and reduces the asset level and valuation of that company .  The balance sheet is reduced, and the company is worth less after that cash is distributed.  

The same thing happens to each share of that company's stock when a dividend is paid.  If the share price is $100 and the company pays a dividend of $1 per share, that stock price drops to $99. So now, you, the investor, have $99 of stock and a dollar bill in your account - the same $100 you started with.  But... that may not quite be what you're left with as you'll owe taxes on that $1 if the stock is held in a non-retirement account.  Assuming that's the case, you'll now pay taxes on that full $1 x (# of shares held).  So on $100,000 of stock, you'll owe taxes on $1,000.  There's a strong chance the dividend is paid quarterly, so that's $4,000. Add that to your taxable income for the year, increase your AGI by the full $4,000 and pay the appropriate taxes (15% is the norm but it could be higher or lower). 

Taxes are almost always lower on "income" produced by capital gains than dividends

What if, however, you decided to sell $4,000 of that stock instead?  That's now a long-term capital gain, and you only pay taxes on the gains, not the entire amount.  There are a lot of variables and depending on how long you held the stock and how much you paid, this will alter this calculation.  But the only way the taxes due on the gain would be equal to the taxes due on the dividend would be if you paid nothing for the stock to begin with. But that's almost never the case; there's always a cost basis.  So if your cost basis is $50,000 on the $100,000 of stock and it's all held in one lot, your taxes due under the capital gain sale would be 1/2 of what would be due on the dividend.  

More "income" at 0% taxes

When calculating federal taxes due, the methodology is outlined in the "Qualified Dividends and Capital Gain Tax Worksheet" provided by the IRS.  In that form, they treat qualified dividends and long-term capital gains equally.  But as you remember from the illustration above, when you sell shares, a portion of what comes back to you is your own capital (cost basis) and the remainder are gains.  So, if you have planned ahead and are able to take advantage of 0% long-term capital gains rates, you'll be able to stay in the 0% gains bracket and take more cash out of the portfolio if you sell shares vs. rely on dividends.

Shrinking the Universe

The best way to reduce risk in a portfolio is to diversify properly and widely.  By selecting only stocks that pay dividends, you're limiting your universe of securities to choose from, and the securities you're eliminating likely could add some great diversification benefits.  There are great companies out there that pay dividends, but there are plenty more that don't. Companies that do not pay dividends usually prefer to put their capital to work in other ways (e.g. build a new factory) that can increase the value of the company which ultimately increases the price of the shares of their stock.  By ignoring these types of companies in your portfolio, your correlation goes up without the expectation of higher total return, which is a bad risk/return tradeoff.  By incorporating both dividend payers and non-payers, you are selecting a broader investment mix that has less expected dispersion of returns (lower expected total standard deviation) which is one of the ultimate goals of investing.

$1 always equals $1

If you go out to buy an ice cream cone and you reach in your wallet, does it matter where that dollar bill came from?  Whether it was from a dividend or the sale of a share of stock?  Does the ice cream taste different or melt differently?  Of course not.  What is important is to ensure that your overall plan, taking into account proper diversification, tax planning, and a prudent withdrawal strategy can keep you buying ice cream cones for many more years.  And using a total return strategy is the most prudent way to invest both before and after retirement.

Other Articles and Resources

Do-it-yourself Dividends

Vanguard Debunks Dividend Myth

Irrelevance of Dividends