Once a quarter or so, my mutual funds pay me a dividend and I get all excited. I see them on my online statements that look something like this:
“Hey Katie, look how much we got in passive income this month! That would pay for tons of our expenses even if we quit working. Isn't that awesome?”
“It sure is,” she agrees.
And then I sit back and remember what a dividend really is, and then I'm no longer so happy about it. In fact, I'm a little bit upset.
Revealing yourself as a dividend-focused investor is, in the words of Steve Adams, the “classic tell of the ignorant investor”.
The Dividend Community
Yet there are entire blogs, books, forums, Facebook groups, etc. all focused on buying shares of stock in order to get dividends. Let me share an example from a recent blog post from the Dividend Diplomats:
It's great, right? This investor only had $423 in dividends in 2011 but in 2019, received over $15,000! Clearly, he's on to something. Well, that's actually true. He is on to something. I am super happy for his success. But it has nothing to do with the dividends. So what is he on to exactly?
- He makes a lot
- He save a lot of what he makes
- He invests his savings in a reasonable way
- He lets compound interest work
But none of that has anything to do with the dividends.
What Is a Dividend?
Classically, a dividend is the payment you get for being an owner. It's your share of the profits. If the company you own was actually profitable after adding up all of its income and its expenses, it will often send you some of those profits in the form of a dividend. On average, US stocks pay a dividend of about 2%. Some pay more, some pay less, many pay none at all. If you own stocks in the manner that I recommend (via low-cost, broadly diversified index funds), all of those dividends get paid to the mutual fund. It uses the dividends to pay its expenses, then passes along the rest to you, usually about once a quarter.
Each profitable company has a decision to make with its profits. It can do one of five things with its profits:
- Let profits sit in its bank accounts
- Reinvest profits in the company—buy more factories, buy another company, do more research and development, do more marketing, etc.
- Buy back its own shares
- Send the money to the owners
- Give the money away to charity
Now we own a company, and we get to make these same decisions all the time. Sometimes we let the profits sit in the company bank accounts. Sometimes we take the money out of the company bank accounts and put it in our personal bank account. Sometimes we reinvest it in the company by hiring more people or buying additional services or equipment. Sometimes we give money away (see WCI Scholarship) but we generally just do that on the personal side. Since we already own the entire company, we can't buy back any shares.
All of the publicly traded companies (stocks) in the US face the same decisions. Some of them retain profits, some reinvest them, some buy back shares, and some pay dividends. Typically, a stock will do a little bit of each. The idea is that if the company does not have a better use for the money, it should send it back to the investors to be invested elsewhere.
The Taxation of Dividends
So why does it matter what the company does with that money? I mean, let's create a hypothetical company. Let's say there are 1 million shares of this company, each worth $100. Let's say the company had a pretty good year and made $8 Million dollars, or 8%. It is now worth $108 Million, or $108 per share. What are the consequences of the five options discussed above?
- Retained profits: The corporation will pay taxes on this money at corporate tax rates. Now shares may be worth $106 and company is worth $106 Million.
- Reinvested profits: No taxes due, as the profits disappear (they were put toward a business expense). Assuming the company made a good investment, shares are still worth $108 and company is still worth $108 Million.
- Stock buybacks: The corporation pays taxes on the money at corporate tax rates. It uses the $6 Million left to buy shares of stock at $106 a share. It buys back 56,604 shares, leaving 943,396 shares. The company is now worth $100 Million, but the shares are worth $106 a share.
- Dividend: The corporation pays taxes on the earnings at corporate tax rates. It sends the $6 Million left to the investors. The company is worth $100 Million. Shares are worth $100 a share. An owner of one share now has $6 in cash and $100 in shares, for $106 total. However, the owner now pays taxes on the dividend, perhaps $1 per share, and is left with $5 in cash and $100 in shares, for $105 total. If investing in a tax-protected account, the investor would have $106 total, of course.
- Charity: The corporation gives the $8 Million away to charity. The investors revolt, the stock price craters, and the company becomes worth just $25 Million and shares are worth $25. (In reality, a C Corp can deduct a charitable gift of up to 10% of its adjusted gross income [25% in 2020] but actually, corporations only give about 1% of earnings on average.)
As you can see, after tax, the best option for the investor is for the company to reinvest its profits. ($108/share total). Next best is to simply retain the profits or use them to buy back shares ($106/share total). Paying out dividends is the fourth best option ($105/share total). Giving the money away is the worst option ($25/share total).
So now explain to me why so many investors get excited about getting a dividend? Yes, you should be excited that your company is making money. But no, you should not be excited that the company is actually giving it to you.
As you can see, a dividend is really just a mandatory, taxable return of capital.
How Much Income Do You Want?
Let's step back out of the corporate world for a minute and talk about your own personal little financial world. I want to do a little thought experiment. I want you to ask yourself how much income you want. Go ahead, think about it. At first glance you might say, “As much as I can get.” But when you think about it some more, you will come up with the correct answer, which is that you do not want any income at all. Income means taxes. The less income you receive, the less you pay in taxes. If you spend $100,000 a year, and you pulled that out of your checking account, you have zero income, pay zero in taxes, and still got to spend $100,000 a year. Awesome, right? But not very realistic.
More realistically, you want your income to be about equal to your spending. If you earn $400,000 a year, but spend $100,000 a year, you will pay taxes on $400,000. If you earn $100,000 a year, you can still spend $100,000, but you only have to pay taxes on $100,000.
“Yes,” you might object, “but I would still have that other $300,000 less taxes (perhaps $75,000) and getting $325,000 is better than getting $100,000.”
But what if I told you that I would still compensate you $400,000, but $300,000 of it would be deferred, meaning you do not yet have to pay taxes on it. In fact, you wouldn't have to pay taxes on it until you spend it years or even decades from now. And, it would continue to grow in this tax-protected way. In fact, if you never spend it, your children will get it, and the taxes will never have to be paid. Interested? Of course you would be.
But a company that pays dividends is basically telling you, “I don't care that you don't need all this income right now. I'm going to make you take it and pay taxes on it anyway.” That's not very nice of them, is it? And you shouldn't be excited about the fact that they're treating you this way, much less bragging about it on Twitter or your blog.
For the last 15+ years, my income has been higher than my spending. It would be awesome to defer all of that income until I actually needed to spend it, letting compound interest continue to work on it in a tax-protected manner. But a dividend investor is somehow trying to argue just the opposite. It's a pretty weak argument.
Declare Your Own Dividend
But if you don't get paid dividends, how will you get income when you do need it? I mean, stocks only pay 2% dividends on average but you know you can take out about 4% of your nest egg a year to spend in retirement. Well, it turns out you can “declare your own dividend” any time you want. You simply sell shares. Those shares get long-term capital gains treatment (i.e. taxes are exactly equal to those of qualified dividends). Except you get to choose when you get that income and pay those taxes. Those years or even decades of tax-deferral boost your returns further than if you had to sell some every year, pay taxes on it, and then (possibly) pay a commission or bid/ask spread to reinvest it (i.e. what dividend investors are so excited about doing).
The Dividend Counter Argument
As you can see, per financial theory, dividends are not a good thing. All else being equal, it would be better for the company to reinvest its profits and for you to “declare your own dividend” at some point down the road than to get dividends every year. However, it would be facetious of me not to address one other point that dividend investors make. They argue that “all else is not equal”. They argue that companies that pay dividends are better companies to invest in. They argue that corporations can fudge the numbers on their financial statements, but they can't fudge dividends. Dividends are cold, hard cash. They may even argue that corporations do not reinvest profits well, and the owners would be better off getting those dividends even after paying taxes on them, but that argument is dramatically weakened by the fact that so many of them participate in DRIPs (Dividend Reinvestment Plans). Here's an example of that argument:
The very long-term data, limited as it is, does suggest that value companies outperform growth companies. That hasn't been the case for 10 plus years now, but I suspect they still will over my investment horizon. One mark of a value company is that it tends to pay higher dividends. Essentially, the company is not growing as quickly and does not have a great way to reinvest its earnings so it pays them out to investors. So a dividend investor generally has a “value tilt” in their portfolio. That's not such a bad thing if you think value stocks will outperform growth stocks in the long run. But even if you believe that, Larry Swedroe would argue that dividend yield is not necessarily the best measure of value or even another related “factor”, quality. He likes price to book value as a metric rather than dividend yield.
Bottom line: Don't bother rejoicing when you see the dividends roll in each quarter. You don't need dividends for compound interest to work on your investments, and they're producing a tax drag on your taxable portfolio that isn't helping matters.
What do you think of dividends? Do you tilt toward them? Were you surprised to learn they are really just a return of capital? Comment below.
I freaking love my dividends. You can pry them from my cold dead fingers 🙂 mine are mostly in my Roth anyway.
this article is really poorly written because it’s from one standpoint only and that is the people that are working and have years ahead of work. I have set up to get $1,500 on average per month in dividends because I don’t care about reinvesting in the future I just want my dividends now as kind of an auxiliary source of income.
I agree. If you’re spending them as you get them there is no tax downside. But no advantage either.
If you are spending dividends as you receive them, do you think there is an advantage to at least having some dividend producing stocks? If you are only selling shares for cash and you sell in a down market you might be forced to sell pennies on the dollar. If you have some dividend income to help you weather the down market you may not be forced to sell in a buyer’s market.
A dividend not reinvested is no different from a share sold, either to the company or to the taxman. Same, same. I know it takes a while to wrap your head around that, but that’s the way it is. There’s a reason Berkshire-Hathaway/Warren Buffett pays no dividends. He is trying to help his investors as much as possible.
The good news if you’re actually spending the dividends is that you’re not getting penalized by the taxman for the company issuing those dividends like you would be if you were not spending them, since if you didn’t get the dividend you’d be declaring your own (and paying taxes on it). Although to be fair, the entire dividend is taxed at 0-23.8%, whereas only part of a stock/fund sale would be taxed at 0-23.8%, since some of it is basis. You only pay taxes on the gains.
A couple of questions. I do understand that getting a dividend is a return of capital because the share price obviously increases during the month or quarter in which it’s making that money. Hence the amount of the dividend is slowly being added to the share price, then when it’s distributed that share price decreases back. So I can see it’s six of one half a dozen of the other whether they keep the money in the company and do something good with it or give it to shareholders. I think that’s a point well taken though certainly not conclusive. That is to say perhaps there’s some data somewhere but I don’t think it’s a foregone conclusion that not getting a dividend and leaving the money in the company is inherently intrinsically better than taking possession of the same money.
Also one last thing that you wrote was that dividends are not necessary for compound interest to work. I wondered what you meant by that wine? Some sort of distribution is certainly necessary for compound interest to work. Unless you mean that the share prices increasing overtime as the company keeps its money and reinvest it also produces the effects of compound interest, just behind the walls of the company?
Thanks for all you do!
The day before the dividend is declared, the money that forms the dividend is part of the capital of the business. The next day, it is a dividend. It’s not basis (your invested principal), but it is capital. Hope that is clear.
Tax-wise, it is better to leave it in the company. But you’re right, whether it is better to have it in hand or have it reinvested depends on what the company does with it.
Distributions absolutely are not necessary for compound interest to work. Look at Berkshire Hathaway which has never paid a dividend. Look at Microsoft that didn’t pay one for years. Compound interest works just as well on reinvested earnings as on paid out earnings that you reinvest manually. No dividend required.
Yet what is Berkshire Hathaway mostly invested in? Dividend paying stocks.
I suspect Buffett would have bought them with or without the dividend because he clearly understands this concept. It wasn’t the dividend that made him buy them, it was the earnings and the way the company was run.
For Buffett, the dividends are irrelevant. He bought the shares because he believed it was a good company.
Very much doubt it’s irrelevant. His favorite holding time is forever. Forever gets you no actual cash from your investment. Say what you want, but his largest holdings are dividend paying stocks. And I don’t see him sending the dividends back.
You don’t seem to understand that for non dividend investors the cash come from selling. I would much rather do my own sellings than somebody forcing me to take the dividends.
Yes, if your favorite holding time is forever, a dividend is basically a forced sell.
Thanks for the clear reply. That did clarify the question I had about compound interest. That is to say whether you’re receiving interest or dividends and parlaying it back into your investment or the company is doing the same with its bottom line creates the same scenario.
The more I learn, the more I lean toward a total return style of investing. (and specifically indexing) I own rental properties and of course the mantra among landlords is cash flow, cash flow, cash flow, you can’t buy a cup of coffee with equity, etc. And so mentally I’ve carried that way of thinking over to my investing. I do have a small allocation (5%) of nothing but high dividend alternative investments like REITs, mREITs, bdcs, mlpas, and closed end funds. But I try to keep that style from a leaking out into my core index strategy.
To be fair, it’s a little harder to sell off 2% of your investment property to spend than 2% of your index fund shares. Cash flow matters a lot more there.
> I don’t think it’s a foregone conclusion that not getting a dividend and leaving the money in the company is inherently intrinsically better than taking possession of the same money
To think that a company would leave it in cash indefinitely is kind of ridiculous. they would have eventually used it for something, whether that was to pay down debt, grow their business, purchase another business, or for use as share buybacks.
Additionally, the point isn’t that dividends are particularly bad (concentration risk in non-dividend paying companies results in the same problem as concentration risk in high-dividend paying companies), but rather that dividends are not free money — they come out of the value of the business and therefore the share price. The only difference being that you can not compound and earn money on the taxes that you would otherwise delay payment on (i.e. you miss out on an interest-free loan from the government).
Really enjoyed this post! I haven’t really cared much about dividends or how much a fund pays out in them. I just reinvested them and kind of ignored them. But to be honest, I did that mostly to keep things simple. Glad to have a better understanding of if this, thanks!
I logically agree with your title, but not so much the negative tone of this piece. Dividends are a reality of investing and many/most of the highest quality most stable companies issue them and therefore nearly every index fund will produce them. The “Non ignorant” investor recognizes this fact and incorporates it into their planning. I have read dozens of posts about the 4% rule but none that I can recall that clearly discuss dividends as a crucial part of this planning. One should determine the dividend yield of their overall portfolio and incorporate that reality into their overall safe withdrawal planning and tax planning.
Thanks for what you do! Perhaps the title is just clickbait (I would have clicked anyway) but the overall tone of this post may turn off many readers early on and a “teachable moment” could be lost.
That’s because it isn’t a crucial part of the planning. Whether you get dividends or not is irrelevant as discussed in the post. Want 4% from the portfolio? The portfolio pays a 2% dividend? Then takes 2% of your 4% as a dividend and sell shares for the other 2%. You’ll pay qualified dividend rates on the first 2% and long term capital gains rates (coincidentally equal to qualified dividend rates) on the second 2%.
The tone is negative in order to help people understand how many wrong ideas there are out there about dividends. In fact, most of the commenters so far (including you) have had at least one idea about them that the article disproved.
I am not sure what you “disproved”. Actually you proved my point: dividends do matter because you have figure out (plan) what to do with them especially when retired and drawing down your portfolio. Maybe the word “irrelevant” means something else to you, but I see it as a relevant issue that an investor must understand and manage.
“because you have figure out (plan) what to do with them especially when retired”
I have no idea what you are arguing. As near as I can tell you’re saying “dividends are relative because many stocks pay dividends.” Is that your argument?
Many stable companies issue dividends, some because they are decades old and slashing the dividend is seen as a sign of financial weakness, and some issue dividends merely because it is seen (rightly or wrongly) as a sign of stability (see Exxon comment below…financing dividend with debt doesn’t really signal financial soundness to me). So it’s a bit of a circular logic problem that stable companies issue dividends to continue to appear stable. Part of the tone of the post is to convince readers not to get drawn into that hype any more than they should buy into the argument that active fund managers can beat the market over a long period of time.
WCI, your hypotheticals are cut and dry. they dont take market/investor psychology into account. A dividend paying stock may be perceived to have greater value beyond its true value, and therefore may actually be “worth” more. Thus investing in dividend paying stocks may be more profitable, all else equal. Sort of a self-licking ice cream cone. 😉
“May be” can be used to justify a lot of ideas.
But, qualified dividend are taxed at 0% up to approx 40K for a single person. Isn’t this very attractive to those who have retired early and have no other income?
So is the long term capital gain when you “create” your own dividends
Sure. But you get the same 0% on long term capital gains. Same, same.
Dividend are either “qualified “ or they are ordinary income. A couple with a MAGI up to $78,500 pays zero taxes on qualified dividends. When you add the $24,500 tax exemption that adjusted income is $103,000. ROTH withdrawals do not count toward MAGI.
Creating your own dividend makes the assumption your stocks are always going up in value which is not the case. When you hit an inevitable downturn and are forced to sell to “create your own dividend,” you are at the mercy of the market. Just look at what happened last March. Stock prices crashed, yet few companies reduced or eliminated their dividend. Guess who favors dividend paying stocks? Warren Buffet. I would offer that he’s probably not an ignorant nor illiterate investor.
When stock market goes down, dividend paying companies keeps paying dividends, that is exactly the same as to sell shares. Warren Buffets Bershire Hathaway pays 0 dividends.
No, it absolutely does not. Dividends get issued whether the stock goes up in value or it doesn’t. You can declare your own dividend whether the stock goes up in value or it doesn’t.
You’re entitled to your own opinions, but not your own facts:
1) 63 S&P 500 stocks cut their dividend in 2020: https://www.cnbc.com/2020/07/16/dividend-cuts-may-mean-rethinking-your-retirement-income-strategy.html
2) Warren Buffett is so against forced dividends that his company, Berkshire Hathaway, has never paid one. He considers himself a value investor. He likes to buy good companies at a good price. Many value investors end up buying companies that pay dividends. But he certainly understands the tax inefficiency of forced dividends. Lately, he’s been doing stock buybacks with the money.
https://cliffcore.com/the-reason-why-berkshire-hathaway-doesnt-pay-dividends/#:~:text=Simply%20put%2C%20Warren%20Buffett%2C%20who,reinvested%20back%20into%20the%20company.
https://www.fool.com/investing/2017/04/16/why-warren-buffett-loves-dividends-but-doesnt-pay.aspx
I’m using the same reasoning.
Here it is in his own words:
That’s from his 2012 letter, from which I’ll quote more: https://www.berkshirehathaway.com/letters/2012ltr.pdf
Hope that helps.
SportsDoc – also, Exxon took on boat loads of new debt to keep its dividend (eg the dividend is financed by debt not profits). Does that sound like a good idea?
You’re cherry picking one stock? All I’m saying is Buffet’s largest holdings are all dividend payers. To call investors that buy dividend stocks illiterate or ignorant is just silly.
I buy dividend stocks. All of them, via index funds. They’re certainly not illiterate or ignorant to buy them. Unless they’re buying them preferentially. Then they’re at least a little financially illiterate or ignorant.
From a Canadian perspective: Only 50% of the capital gain is taxable, but all in the year that it was realized, even though it may have taken 20 years from the time the principal was invested. If you are self employed you may have had minimal income for years with little or no excess funds to invest, and invested what you could in dividend producing investments to augment your ‘no wage status’. Fast, high capital gains are great, but they require finding an investor stupid enough to pay what may be an over inflated price. That is the way I see it.
JS.
How does that compare to dividends in Canada? Maybe dividends are even worse tax wise in Canada than in the US. We’d love to only pay taxes on 50% of capital gains, although I would guess the rates are higher in Canada. Maybe that makes up for it.
Taxation of dividends in Canada is different. Canadian company dividends get preferential treatment such that up to about $80k income, these “eligible”dividends are taxed at a lower rate than capital gains. For foreign dividends, they are taxed as interest income.
That makes for some complicated calculations for our Canadian friends.
I agree with everything in the post, but it’s worth mentioning that dividends made more sense when 1) selling shares had to go through a broker and carried significant costs on its own and 2) transactions in fractional shares weren’t feasible (so if a stock traded at $500 but you only needed/wanted $50, you were out of luck). Dividends are a bit like a vestigial organ of finance in that way, and perhaps why you see a lot of older people still tilted toward them.
I agree that there are historical factors for sure and that things are different now in some ways than they might have been 25, 50, 75 years ago.
Also, if tax law changed, dividends would make a whole lot more sense. Imagine if the LTCG brackets were eliminated but the qualified dividend ones were not. Then dividends would be great and I’d hope to see lots of companies increase theirs.
Don’t hate the dividend….hate the tax code. The fact that the company is profitable and prioritizes paying is owners is commendable. The fact that the government taxes this twice is deplorable. Run down or change the tax code not the dividend.
Totally agree. Eliminate taxation of dividends and I wouldn’t complain about them at all. I could always just reinvest them without consequence in that scenario.
Well, elimination of taxation of dividends still wouldn’t be enough, right? In the Buffett example you pasted above, there is still the premium of buying at 125% in the open market, right? Am I missing something?
Also, does Berkshire basically swallow the taxes from the dividends of their underlying companies and not pass it on to their customers? That sounds awfully nice of them, or am I missing something else here?
You lost me with the 125% premium comment. Can you ask it in a different way?
Not sure about Berkshire Hathaway tax situation, but if Berkshire is paying taxes, their shareholders are paying them indirectly.
I was referring to Buffett’s 2012 letter you posted in one of the reply threads above. In the example he sets forth, he makes an assumption that on the open market it costs 125% to buy a share. So when you get a dividend and re-invest it, you’re losing both taxes and you’re paying a premium to re-buy the same stock at the open market rate. So the point I was trying to make was even if govt decided to not tax dividends, dividends might still be unfavorable for someone who just wants to HODL.
As far as Berkshire’s tax situation goes maybe their stock price falls when they pay taxes. Or atleast, their book value must fall to accommodate the taxes paid. I think.
Interesting thought. I’ll have to noodle on that one.
Excellent post jim. You’ve really touched on a point about dividend investing: It can end up being a return OF your principal, not always a return ON your principal.
For (most) dividend investors, there appears to be a psychological “rush” to receiving the dividends. It seems similar to what real estate investors talk about with “mailbox money”. However, at least their income can be offset by depreciation.
Regards,
Psy-FI MD
Nice balanced article. If one is CURRENTLY a high income earner, yes, I would definitely avoid high dividend stocks outside tax protected accounts.
The real issue is “Are you confident the company you are investing in will make good use of its profits?”. Sometimes that is reinvesting, sometimes it is retaining because they see things on the horizon, and sometimes it is distributing (dividends).
Personally, I just want to feel management is focusing on maximizing value, not focusing on being an dividend aristocrat, or likewise always reinvesting in projects that may not be the best use of capital.
WCI,
Well said and the same drum I have been beating on for a number of years and recently wrote a couple of blogs showing the math:
https://seekingalpha.com/instablog/3752451-financialdave/5287623-is-magic-in-dividends
and
https://seekingalpha.com/instablog/3752451-financialdave/5347859-dividend-what-is-good-for
In the second blog I actually took a real portfolio and found the total return of it and found another non-dividend paying stock with an almost identical total return and pulled the same income from it as the dividend portfolio. The results were as you would have expected – pretty much identical.
Dave
When I took over my taxable accounts from my Financial Advisor, I selected to automatically reinvest the money without thinking. Now I am looking at all the dividends in my account and appalled at the results. I am trying to rid myself of individual stocks only to see that I am now getting fractional shares that have different cost basis’ and a bunch of short-term gains that I don’t want.
Realizing the error of my ways, I turned off the automatic reinvesting feature and will plan on accumulating the dividends and reinvesting manually. Still I don’t get all the fuss, when you can simply sell and manage your own investments to create your own dividends as you suggest. It is much more straightforward and manageable!
Yes!
I’ve been beating this drum for years. This week, I’ll receive something just shy of $10,000 in dividends, but it will be less than $8,000 in my pocket after Uncle Sam gets his share.
Yes, qualified dividends and long-term capital gains can be taxed at 0% if your taxable income is under ~ $80,000 (and this is great for early retirees), but while working, most high-income professionals will pay 15% to 20% + 3.8% NIIT + state income tax in 40+ states. I would guess the average reader of this site loses a quarter of his or her dividend “income” to taxation.
State income tax and the NIIT (ACA surtax) are usually left out when discussing the pros of dividend investing.
Thanks for the post!
-PoF
Thank you for writing a comprehensive and well-reasoned article AGAINST dividend investing. I try to tell my colleagues the same thing, but they cannot seem to understand the rationale behind it. Perhaps this will help them.
I agree with the article. I don’t reinvest dividends; my dividends are simply a “rebalancing” tool. They typically come from my growing stocks, and I “rebalance” them when received, into my stock/bond positions that are currently underrepresented.
Dividends are a comfort to those who are a bit deer in the headlights when it comes to investing. If it encourages investing and avoids decision paralysis it may be worth the suboptimal returns…
Are there any studies comparing investment performance of those who automatically reinvest dividends vs those who do it manually? I would think that auto-reinvestment would win out in the end.
Wouldn’t surprise me. Just as lots of people leave their 401k money in cash and never invest it, lots of people who don’t reinvest automatically probably don’t reinvest the money at all. The benefit of making it automatic likely outweighs the benefits of not reinvesting dividends for most. No reason not to reinvest them in a tax protected account. I think there are good reasons not to reinvest them in a taxable account, but you’ve got to make sure you’re one of the few who will actually get the money reinvested relatively soon.
Jim – Why ITOT over VOO? and why all ETF’s and not Mutual funds?
Thanks
Justin
You mean ITOT over VTI? Or why a total stock market fund over a 500 index fund?
I tax loss harvested from VTI to ITOT.
I prefer total stock market fund over 500 funds for their additional diversification.
ETFs and mutual funds at Vanguard are 6 of one and a half a dozen of the other. Doesn’t matter. Was in Total stock market fund and TLHed into large index fund and TLHed into 500 index and TLHed into ITOT and then the market went up. So I was stuck with ITOT (and IXUS). And I’ve just stuck with the ETFs since. More on that discussion here:
https://www.whitecoatinvestor.com/mutual-funds-versus-etfs/
Thanks Jim. I was more asking about why iShares over Vanguard, but the answer of Tax Loss Harvesting seems the same.
I was inquiring about mutual funds vs ETFs because I thought you favored funds in your taxable account due to lower risk while tax loss harvesting (i.e. risk of fluctuation in the ETF price while in the process of selling one fund and buying another).
Thanks!
I think I do like funds slightly better than ETFs, but it’s a pretty small difference. Maybe I’ll convert back here. Vanguard actually allows you to do that because it’s two share classes of the same fund. The iShares ETFs will be used for our charitable donations until they’re gone.
Thanks Jim. I just did some digging and it looks like you can convert from MF–>ETF without creating a taxable event but to go from ETF–>MF you have to sell and repurchase creating a taxable event.
That’s interesting. Obviously wouldn’t want to do that. I don’t mind managing the ETFs, my preference in that department is pretty slight. I’m already using ETFs in two 401(k)s.
Does the maxim of “No called strikes in investing” apply to whether or not you TLH? I’m planning on moving away from having my wealth managed for 30 basis points. But if I did it myself, I’d probably not TLH, because it’s better for me not to touch the account for fear of being tempted to buy GME or some such. If the benefits of TLH outweigh having to pay 0.3% then maybe I’ll keep having them do the TLH. Opinions?
It’s admittedly a relatively small part of investing. You can certainly be successful without ever tax loss harvesting. Doubt it’s worth 0.3%, but who knows.
Out of the five possibilities listed, only one puts more money into the shareholder’s pocket.
Which means I now have the original stock PLUS additional money. You can argue otherwise – and certainly have – but from a shareholder perspective, that’s a far better deal than the other four options. The fact that some of that additional money is reduced by taxes is meaningless. It’s still additional money that the shareholder didn’t have before the dividend had been declared.
If it were true, a better argument would be how issuing dividends hurts the company’s stock value.
I was under the impression that when a dividend is declared, the stock price is lowered by an equivalent amount.
Chris hasn’t realized that yet, but you’re right. That’s how it works and why Chris’s argument doesn’t make sense. He thinks he has more money after the stock pays him a dividend, but he doesn’t. He has the same amount of money. $103 per share value. Pay $3 dividend. You now have $100 per share value and $3 cash. $103 = $103. Then apply taxes. No free magic money.
Yep, that’s true. I didn’t know the share price got adjusted.
Looking back, I think the example in #4 confuses things a bit. It’s hard to tell the investor owned $106 in shares (not $100) prior to the dividend being issued because the company valuation includes the cash about to be distributed. Regardless, learned something new today. 😉
| An owner of one share now has $6 in cash and $100 in shares, for $106 total.
That’s exactly how it works and the point of this post. MANY investors don’t know what you just learned.
One caveat to this, the Vanguard bond funds don’t work like this. The accruing interest from the bonds in the fund is not added to the NAV like it is with equity funds. So it is in addition to the NAV. If you sell before the dividend is paid, a partial dividend is paid out. I assume other fund families are the same. I don’t think bonds work like this either. So this is a stock and stock mutual fund thing.
I think probably what makes this lesson so obscure and difficult to learn is that share prices are volatile. So that $106 stock that pays a $6 dividend might sell for 112 a share the day after the dividend is paid due to a rise in share price. That $106 stock is never $106 for more than a couple of days hence making it harder to pick up on.
Why bash dividends?
“John Bogle, writing on the website IndexUniverse.com, writes the following: “An investment of $10,000 in the S&P 500 Index at its 1926 inception with all dividends reinvested would by the end of September 2007 have grown to approximately $33,100,000 (10.4% compounded). [Using the S&P 90 Stock Index before the 1957 debut of the S&P 500.] If dividends had not been reinvested, the value of that investment would have been just over $1,200,000 (6.1% compounded) – an amazing gap of $32 million. Over the past 81 years, then, reinvested dividend income accounted for approximately 95% of the compound long-term return earned by the companies in the S&P 500.” In other words, the reinvestment of dividends accounted for almost all of the stocks’ long-term total return.“
You’re missing the point. The earnings compound whether or not a dividend is paid to you by the company.
Great point. I think it’s easy to get into “intellectual snobbery” and focus on the “science” more than “what actually happens” with these things. (i.e. just because something looks good or bad on paper doesn’t tell the whole story)
I believe IN GENERAL, a company keeping its profits and putting that money to work will result in greater appreciation, vs. giving the money as div’s to shareholders. There’s just too many moving parts to say “loving dividends is a sign of ignorance”. The MINUTE someone says “X is a sign of ignorance” or something that SOUNDS like that, I know there’s “overconfidence bias” going on at some level. I think the most important lesson is “don’t look at one thing as a holy grail” (the thing being dividends in this case). When you start getting “ego” involved (i.e. “dividend investors crack me up sometimes” is a perfect example of an overconfidence bias, ego-laced viewpoint), it’s easy to sometimes miss the important “what actually happens” vs. “what my argument shows”.
Excellent points!!
Maybe it comes off as snobbish (tone is notoriously hard to get right on the internet) but I think you’re just reacting to writing style. I’m not the world’s best writer by any means, but I do try to keep it interesting as you slog through what is actually relatively boring content.
As you can see in the comments above, there are a lot of people who don’t actually understand how dividends work. It’s not overconfidence when someone who does understand how they work explains that to someone who doesn’t know how they work. It’s no different than me explaining a clinically important point of pharmacology to a medical student (or more likely the reverse!)
I’m not saying dividends or dividend stocks (all of which I own) are necessarily bad. Certainly if a company doesn’t have a better use for its money it ought to give it to the owners, but they’re not some magic extra money that comes out of the company. They’re just one way in which the owners collect the earnings.
Point well taken!
The thing I like about dividends is that it can help to eliminate sequence of returns risk. For example, if you own a high dividend ETF, it may have a 4% dividend yield. An idex tracking the S&P 500 currently has about a 1.5% dividend yield. When the market tanks, if you own the S&P 500 ETF, you could be forced to sell shares low to meet your spending. However, if you own a high dividend ETF, you may be able to cover your spending with dividends and never be forced to sell shares at low levels. This is the major benefit to dividend investing in my book, the minimization of sequence of returns risk.
I disagree that it decreases sequence of returns risk. It’s irrelevant to it. Value stocks may go down more in a downturn than growth stocks and that’s ignoring the fact that dividends tend to get cut during downturns. You’re just doing mental accounting.
I disagree with your disagreement. This is not about how value and growth stocks will perform relative to one another in a market downturn. Most dividend growth stocks are value stocks, but again, this is irrevelvant to the point I am making. Lets say you need $80,000 a year for expenses. Now let’s say you have $2 million in equities. At a 4% yield, your high dividend ETF will produce the needed $80,000/year. No equities need to be sold off. The S&P 500 ETF will produce $30,000 in income. Thus, you will have to liquidate $50,000 of equities to meet your $80,000 speding needs. The problem is that you may be forced to liquidate the equities when they have fallen significantly in value. If this persists for several years(think 2000-2002), you are being forced to continually sell equities at depressed valuations. Therefore, whenever the market rebounds, you will not be able to participate in as much of the upside as you have been forced to sell shares. In the high dividend ETF scenario, you do not have to liquadate any shares because the dividends cover expenses. Thus, when the market rebounds, you can capture all the gains.
Of course companies can cut dividends during econmic downturns, but the most stable dividend growth stocks (JNJ, PG, MO, etc) have contiued to raise their dividends even through the 2008 downturn and covid crisis. One could cetainly argue that dividend growth investing may not be the best total return strategy, but I have trouble understanding how this strategy does not decrease sequence of returns risk.
I understand your argument. It’s not the world’s worst argument, I just think mine is better. Mine is that selling equities in this situation is no different than spending the dividend. You’re taking the earnings of the companies you own and spending them instead of reinvesting them. Whether you take them as dividends or capital gains is irrelevant.
It is the timing of the selling that is the issue. Assuming a company’s earning stay the same and the stock price drops significantly (as frequently happens with value stocks in bear markets), you are forced to sell shares at a much lower PE ratio than before the stock dropped. A better option would be to let the shares PE ratio rise back up to normal levels before selling . If your dividends cover your expenses, you are never forced into selling share at poor valuations. If you need the money to cover expenses, you will be forced the sell at low valuations and this causes destruction of value. It’s the inverse of Buffet only buying back Berkshire shares at certain price to book ratios. Buying back shares over certain levels is value destroying.
Anyways, thanks for commenting. I’m sure it’s exhausting having minor arguments with 50 people at once!
Derek-
It’s the same thing whether you sell shares at that low PE or get a dividend and do not reinvest it at that low PE. Same-same. It’s purely a psychological game you’re playing with yourself about the dividend.