A warning on dividend investing

[sophie]

This is a very clear description of the dark side of dividend investing:

http://money.cnn.com/2012/10/01/pf/expe ... d=HP_River

I especially like the term "homemade dividends" - i.e., get your own dividends by selling capital appreciation, on your own schedule and with less of a tax bite.  Which of course is built right into the PP.

[AgAuMoney]

I especially like the term "homemade dividends" - i.e., get your own dividends by selling capital appreciation, on your own schedule and with less of a tax bite.  Which of course is built right into the PP.

There were only two things correct in that article:  the problem with dividend funds, and the tax status of dividends vs long-term capital gains.

The rest is unadulterated EMT fantasy, especially "homemade dividends."

Selling assets to generate income only works in appreciating markets.  If markets are flat or declining (and historically at times they have done that for decades) then selling assets forfeits your earning/appreciation and you never recover.  You have to avoid selling assets in those markets.  The "standard" recommendation is to use bond income (but not too much because of inflation costs) plus keep years of expenses in or near cash just in case (but not too much).

It is possible that the PP with its 4 asset classes will work for selling assets because something is always going up, plus you have the large cash cushion to tide you over.  I don't know.

I do know that "real" dividends have worked for over 100 years and selling assets has failed innumerable times.

[sophie]

It is possible that the PP with its 4 asset classes will work for selling assets because something is always going up, plus you have the large cash cushion to tide you over.  I don't know.

The above is the only way that the PP can grow, since the portfolio as a whole does not generate much income (which is what people mean when they describe it as "tax-efficient").  The whole point of the PP is that one asset is always growing, except during tight money recessions when nothing is doing well.

If you're doubtful that this can happen, then you're probably better off sticking with traditional stock/bond portfolios and giving the PP a pass.

[MachineGhost]

This is a very clear description of the dark side of dividend investing:

http://money.cnn.com/2012/10/01/pf/expe ... d=HP_River

Hmm, that is a perspective easy to forget about (that the dividend payment is essentially same as selling shares of a non-dividend paying stock).  It helps to explain why net payout yield (dividends paid, shares repurchased, debt retired) ranks only third as a source of "market anomaly" returns, only ahead of quality.

[AgAuMoney]

Hmm, that is a perspective easy to forget about (that the dividend payment is essentially same as selling shares of a non-dividend paying stock).

Said perspective is incorrect.

I covered the market dependency already.  That is the most significant fallacy in the perspective.  The other related to it is the bit about security prices adjusting for the dividend.

It is brutally apparent to even a casual daily market observer that prices adjust every day on every actively traded security.  While the exchange does make the accounting fiction of adjusting the price of a security by the dividend amount on ex-div, that adjustment is nearly always swamped by the normal price movement on any given day and so is of no meaningful or lasting effect.  The one exception is where a company makes a distribution that is very large relative to their share price or book value.  This happens rarely, but it does happen.  For example, one company this fall is making a $10 per share distribution with a share price at announcement under $5 but a book value significantly higher.  I expect some very weird price action on that unusual situation (but it is a company I'd never buy so I've not paid it any attention since the announcement).  For other examples, see the spinoff of PSX from COP earlier this year, or the many spinoffs or sales of parts of PG over the past at least 15 years or so.

The entire article is based on theory and is of no real world application excepting the two issues I mentioned earlier.

[AgAuMoney]

It is possible that the PP with its 4 asset classes will work for selling assets because something is always going up, plus you have the large cash cushion to tide you over.  I don't know.

The above is the only way that the PP can grow

That is a gross oversimplification.

The key word I used is "always".  If something in the PP were "always" going up then selling would work.

However the PP has historically had extended times when there was nothing going up and in those times you would have to rely on the cash cushion.

I'm pretty certain that is not sufficient, hence my comment in an earlier thread about the PP not generating enough income and my decision to do something about it.

If you're doubtful that this can happen, then you're probably better off sticking with traditional stock/bond portfolios and giving the PP a pass.

Please do NOT be telling me what is better for me.

You do not know me, you have no idea of my level of knowledge and experience and your assuming to advise me is extremely offensive.

[Xan]

Isn't this forum here for people to get advice and give advice to others?  If you don't want advice, maybe you could use your signature to describe your level of knowledge and experience, and that you already have all the answers, so that people don't bother trying to talk to you.

You do have some...  I'll avoid saying "wrong" and just say "unique" ideas which are hard for many of us to understand.

[melveyr]

I especially like the term "homemade dividends" - i.e., get your own dividends by selling capital appreciation, on your own schedule and with less of a tax bite.  Which of course is built right into the PP.

Selling assets to generate income only works in appreciating markets.  If markets are flat or declining (and historically at times they have done that for decades) then selling assets forfeits your earning/appreciation and you never recover.  You have to avoid selling assets in those markets.  

Stocks decline by the amount of their dividend after the ex dividend date. A stock with a dividend does not circumvent the problem of selling in a down market, because the dividend has the same effect as selling shares. You can reinvest the dividend, but then what was the point of the dividend in the first place? The company could have just done a buyback because that is the same effect to you as a shareholder.

The dividend is forcing you to divest in a down market where as with capital gains you have the choice, with greater tax efficiency to boot. Remember that you are an owner of the company, when the company pays you, you are simply paying yourself. Dividends aren't free money, they come directly out of the share price.

[MachineGhost]

I'm pretty certain that is not sufficient, hence my comment in an earlier thread about the PP not generating enough income and my decision to do something about it.

What did you do about it?  Dividend growers?

[dualstow]

This is a very clear description of the dark side of dividend investing:

http://money.cnn.com/2012/10/01/pf/expe ... d=HP_River

Good article, Sophie, and a nice distraction from the nasty cold that I'm in the middle of. The allure of the dark side has always been strong with me, and the illusion mentioned is a powerful one. Before having a pp I was a boglehead, but long before that I was a buyer of individual stocks. My favorite part of investing was dividends.

I think there are two forces at work here. One, if I stop drooling over yield-on-cost (always a bad idea) and look at performance, my dividend stocks have done ok but just ok. If I had taken the same money and only bought a small-cap value index fund it would have been less psychologically gratifying in the short run, but I would have done better in the long run. And paid less tax!

But Two, I had the idea that as long as I started out with enough money, I could virtually guarantee a nice bit of passive income for the future. It wasn't my own idea. I read it online on one of those stark homemade web pages in 1996 when I was first using the internet on a regular basis. And that's not to say that this idea is necessarily wrong. In fact, it has one thing in common with the permanent portfolio: giving up a ridiculously high upside in exchange for a slow but safe, all-but-guaranteed minimum of success. I only wish I had explored other options more thoroughly before jumping into the dividend growth strategy.

A few friends of mine still adhere to the dividend growth strategy. They say that when someone lectures them on total return they smile, nod politely, and cash their dividend check. :-) As for me, I think I'm going to need regular reminders, almost like therapy, to stay on a wiser course if a less intuitive one.

[Gosso]

I think there are two forces at work here. One, if I stop drooling over yield-on-cost (always a bad idea) and look at performance, my dividend stocks have done ok but just ok. If I had taken the same money and only bought a small-cap value index fund it would have been less psychologically gratifying in the short run, but I would have done better in the long run. And paid less tax!

Yield-on-cost can be applied to anything, not just dividends.  Lets assume I bought gold at $250 back in 2000, then fast forward to the start of 2012 where the price of gold has increased to $1750.  Now lets assume that gold has increased to $2000 by the end of 2012 (an annual gain of $250).  If we use yield-on-cost then we get an annual return of 100% for 2012, but in reality the annual return is only 14%.  That's a big difference!

[dualstow]

I think there are two forces at work here. One, if I stop drooling over yield-on-cost (always a bad idea) and look at performance, my dividend stocks have done ok but just ok. If I had taken the same money and only bought a small-cap value index fund it would have been less psychologically gratifying in the short run, but I would have done better in the long run. And paid less tax!

Yield-on-cost can be applied to anything, not just dividends.  Lets assume I bought gold at $250 back in 2000, then fast forward to the start of 2012 where the price of gold has increased to $1750.  Now lets assume that gold has increased to $2000 by the end of 2012 (an annual gain of $250).  If we use yield-on-cost then we get an annual return of 100% for 2012, but in reality the annual return is only 14%.  That's a big difference!

True, but I wasn't talking about about a one-time gain that can only be realized once and that may vanish before you have a chance to realize it. (Something that also exists in the value of the dividend stock too, of course).  I was talking about the common habit of dividend stock buyers to look at the growth of a dividend instead of looking at the current yield on holdings. It probably came up in some of Odysseusa's threads. So, for example, the yield-on-cost of my Chevron shares is 6.2% but the current yield, the one we should focus on, is closer to 3%.
I suppose that could also be annualized. Chevron/CVX's dividend has grown 12% a year over the six years that I've owned it. This annual raise sounds great compared to bank interest rates. But, when I look at all the stocks I bought and compare that to just buying an index fund, maybe it wasn't worth the trouble.

[craigr]

I wrote about some of these issues recently and in the past few years:

https://web.archive.org/web/20160324133 ... dex-funds/

There is no problem harvesting capital gains to pay bills in the Permanent Portfolio. In virtually all cases it's much more tax efficient to do things this way so as to not add income to your current tax bill. If you are below your annual limits on withdrawals that you've set, there is no problem doing this. Not only can you then manage taxes so you pay only what you want, but there is the other side that through stock splits the stocks you sell can overtime recover inside the funds you sell down. Plus you have the bonds/gold in the portfolio you can harvest for gains when the stocks are lagging.

All things considered, for purposes of the Permanent Portfolio, I would prefer to avoid funds paying high dividends.

[Reub]

Dualstow, you might want to try some Vitamin D (you can take a single dose of 20,000 IU's if you like) and some zinc lozenges as well. That combination usually eliminates my cold in less than a day.

[stone]

AuAgMoney,
[quote] The key word I used is "always".  If something in the PP were "always" going up then selling would work.
However the PP has historically had extended times when there was nothing going up and in those times you would have to rely on the cash cushion.
I'm pretty certain that is not sufficient, hence my comment in an earlier thread about the PP not generating enough income and my decision to do something about it. [quote]

I sort of expect (but obviously don't really have any clue) that all the major fiat currencies will turn Japanese with zero interest rates and inflation and endlessly sideways markets. I'm wondering whether in such a scenario the PP would function better if it were to have much tighter rebalancing bands (say 20% to 30%). That might generate some steady modest trading profits giving pseudo-income even when asset prices were just aimlessly bobbing about rather than heading anywhere. I wonder whether 15% to 35% bands might be more suited to younger fiat currencies rather than the mature Japanese type. Ofcourse this is just rank wondering because no fiat currency has ever "matured" in the past.

[dualstow]

Dualstow, you might want to try some Vitamin D (you can take a single dose of 20,000 IU's if you like) and some zinc lozenges as well. That combination usually eliminates my cold in less than a day.

Thanks. It's running its course thanks to hot soup.

Just think, when I inevitably catch another cold in December, I'll be thinking about how I paid zero taxes on dividends last year. Two December's from now? Not so sure. :-)

[AgAuMoney]

Isn't this forum here for people to get advice and give advice to others?

When I want advice I'll ask for it.

K?

[AgAuMoney]

Stocks decline by the amount of their dividend after the ex dividend date.

That's true.  They do adjust the previous day close by the amount of the dividend.

But then the stocks also decline more or sometimes they go up as soon as the market opens.

Just like any other day.

In other words, for the typical dividend, there is zero net impact on the stock price.  The only time you see something significant is if the dividend is huge relative to the stock price or book value.  (Like a $10 dividend on a $4 stock that was announced a month or so ago.)

[AgAuMoney]

I sort of expect (but obviously don't really have any clue) that all the major fiat currencies will turn Japanese with zero interest rates and inflation and endlessly sideways markets. I'm wondering whether in such a scenario the PP would function better if it were to have much tighter rebalancing bands (say 20% to 30%). That might generate some steady modest trading profits giving pseudo-income even when asset prices were just aimlessly bobbing about rather than heading anywhere. I wonder whether 15% to 35% bands might be more suited to younger fiat currencies rather than the mature Japanese type. Ofcourse this is just rank wondering because no fiat currency has ever "matured" in the past.

( Is that quote and attribution correct?  I tried...)

I've been using 20%-30% since 2008.  Harry endorsed that tighter spread a few times.  His warning was to beware of extra transaction costs and possible tax consequences of the extra activity.

I would caution that too frequent rebalancing increases the risk that you'll cut your winners short and dump funds into a falling position.

My rational for narrowing the spread is because I don't believe the market has a solid trend.  So as long as it seems this volatile I'll rebalance at the tighter limits.  If things go back to more "normal" (whatever that is) I'm planning to let my spreads widen.  But if it has been a year since I rebalanced and it is 5% out I'll rebalance.

[Pointedstick]

Stocks decline by the amount of their dividend after the ex dividend date.

That's true.  They do adjust the previous day close by the amount of the dividend.

But then the stocks also decline more or sometimes they go up as soon as the market opens.

Just like any other day.

In other words, for the typical dividend, there is zero net impact on the stock price.

True, but those reinvested dividends incur taxes in a taxable account. Even though the dividend can be immediately reinvested thereby avoiding the hit you would take if you just spent it, you get taxed for it anyway. So the dividend becomes a slow tax leak for funds held in taxable accounts. Stupid IRS.

[AgAuMoney]

reinvested dividends incur taxes in a taxable account. Even though the dividend can be immediately reinvested thereby avoiding the hit you would take if you just spent it, you get taxed for it anyway. So the dividend becomes a slow tax leak for funds held in taxable accounts. Stupid IRS.

Yeah.

There are some strategies...

For example, Master Limited Partnerships pay a distribution that is not a qualified dividend, but is instead almost entire classed as a return of capital, and thus tax exempt in the year of distribution.  It does reduce your basis so a tax hit when you sell, and you have to deal with a K-1 on your tax return every year.

Another example, there are companies that pay some or all of their distribution in the form of shares.  This is treated as a non-taxable event (like a stock split).

And of course any losses can be harvested to offset some of your income.

I wish I had a bit more of these problems...  I'm over 70% tax advantaged and I'm trying to get the taxable a bit more in balance.

[sophie]

I think there are two forces at work here. One, if I stop drooling over yield-on-cost (always a bad idea) and look at performance, my dividend stocks have done ok but just ok. If I had taken the same money and only bought a small-cap value index fund it would have been less psychologically gratifying in the short run, but I would have done better in the long run. And paid less tax!

That's exactly it, dualstow:  dividends are like a security blanket, and that's a powerful psychological force.  To cure it, try plotting your fund with the S&P 500 index.  Then consider that you're converting capital gains to ordinary dividends that are then taxed into oblivion.  Individual stocks might be a better deal, though, if the dividends are qualified (depending on what happens with those tax cuts come January).

One thing the article talks about is how dividend investing leads you to over-invest in a small number of market sectors, which paradoxically could be more risky.  That may be especially true now, because people are piling into dividend stocks and it's causing a bubble that will break one day.  Watch out!

Stocks decline by the amount of their dividend after the ex dividend date.

That's true.  They do adjust the previous day close by the amount of the dividend.

But then the stocks also decline more or sometimes they go up as soon as the market opens.

In other words, for the typical dividend, there is zero net impact on the stock price.

Huh????  The logic of this completely escapes me.  What you mean is that the stock price decrement is hidden by the normal fluctuation, but that doesn't mean it's not there.

[dualstow]

try plotting your fund with the S&P 500 index.  Then consider that you're converting capital gains to ordinary dividends that are then taxed into oblivion.  Individual stocks might be a better deal, though, if the dividends are qualified (depending on what happens with those tax cuts come January).

My dividends are nearly all qualified. I was excited that I didn't have to pay any tax on them last year, but I certainly don't expect that to last. Soon, my div stocks will be like a once entertaining lodger that still pays his rent but keeps spilling wine on the couch.

One thing the article talks about is how dividend investing leads you to over-invest in a small number of market sectors, which paradoxically could be more risky.  That may be especially true now, because people are piling into dividend stocks and it's causing a bubble that will break one day.  Watch out!

Once guilty and still repenting. Well, I hope people keep piling in. It'll make it easier for me to sell. 

[stone]

Stocks decline by the amount of their dividend after the ex dividend date.

That's true.  They do adjust the previous day close by the amount of the dividend.
But then the stocks also decline more or sometimes they go up as soon as the market opens.
In other words, for the typical dividend, there is zero net impact on the stock price.

Huh????  The logic of this completely escapes me.  What you mean is that the stock price decrement is hidden by the normal fluctuation, but that doesn't mean it's not there.

Sophie, what seems to get overlooked is that an oscillating asset price can in itself provide an income stream BUT ONLY to those holders who harvest that volatility by rebalancing or selling call options or whatever. So stocks tend to represent a trade off between either zigzaging in price by a lot or paying a dividend. If you consider yourself to be very good at harvesting the volatility of individual stocks then it makes sense to stick to non-dividend stocks. Otherwise IMO you might just be handing over the earnings of the stocks you own to those guys that do harvest the volatility that you let pass by.
I guess it pays to think about what non-dividend paying companies do with their cash flow. They often do buy-backs and use employee share options to dilute the stock by the amount they buy back. Or they buy smaller companies or they fund expansion or pay down debt. I guess many of the non-dividend companies are wracked by debt. When times are good they pay down debt and buy small companies, when times are tough they need to break up and sell off bits of themselves to meet debt obligations. All of that gets translated into price gyrations NOT some fantastical smooth ballooning of the stock value. Any given company won't last forever. Without harvesting volatility or taking a dividend, its possible to get nothing from holding a share for the entire life of a company.

[stone]

I thought that this comment from the link below summed this up well:
http://www.indexuniverse.com/publicatio ... ml?start=3

By Jim B. | July 12, 2011
I agree with the other commenters. Trying to represent that adding buybacks to dividends equals a much higher total return is simply nonsense when the total number of companies with net buybacks is just a handful. Last time I saw the "net buyback" corporate list, there were fewer than ten S&P 500 companies on the list. Further, anyone who follows buybacks knows that the CEO's are most exhuberant about buying their stock when it's at highs for a period and almost never during down periods. Contrary to what this author is saying, buybacks are therefore skin off the investor's total return. Last down period I can recall when corporations were aggressively buying back during a downturn was in Oct. '87 crash when John Phelan urged them to do so to show confidence in the market. They sure didn't buy back a lot at the lows of March 2009; they are buying heavily now after a 99% advance. Corporations buy back stock over paying dividends for the simple reason that that benefits the insiders with options. Kind of shocking that a dividend ETF shop is this naive!!