Watch Now
Listen Now
In this episode, we’re diving deep into the world of dividend investing with Taylor Schulte, a fellow member of the Retirement Podcast Network. Taylor recently did a fantastic four-part dividend investing series that served as the foundation for our conversation.
Dividend Investing (Part 1): Making Money While You Sleep
Dividend Investing (Part 2): Three Reasons Why Dividend Strategies Underperform
Dividend Investing (Part 3): A More “Flexible” Dividend Strategy
Dividend Investing (Part 4): Answering Top Listener Questions
Together we debunk common dividend myths, explore the pitfalls of focusing solely on dividend yield and analyze the performance of dividend-focused funds compared to the broader market.
Here are my notes from our conversation…
Sign up for my newsletter so you can easily reply to my emails with your thoughts or questions for the podcast:
Introduction to Dividend Investing and Common Misconceptions (0:30)
Dividends are a portion of a company’s profits shared with shareholders. The three primary ways companies use profits are: reinvesting in the company, paying dividends, or buying back stock. These options impact the company’s stock price and overall valuation.
We explain how the ex-dividend date works, and clarify that buying a stock right before the ex-dividend date to collect the dividend and then selling it does not yield extra profit, as the stock price adjusts to reflect the dividend payment.
Taylor illustrates this with a simple example: if a stock trading at $50 per share declares a 50-cent dividend, the stock price typically drops to $49.50 after the dividend is paid. This adjustment means that investors are not gaining free money from dividends, but merely receiving a portion of their investment in a different form. The tangible nature of dividends often misleads investors into believing they are an additional return, which is not the case.
Building a Portfolio: Yield Focus vs. Total Return Approach (4:45)
Focusing too much on dividend yield when constructing a portfolio can lead to a riskier portfolio with lower future expected returns. Taylor emphasizes that investors should not let the yield of an investment dictate their portfolio’s risk-return profile. Instead, they should allow their financial needs, goals, and risk tolerance to drive portfolio construction.
Taylor outlines a three-step process for constructing a well-balanced portfolio. Step one is determining which asset classes belong in the portfolio based on a financial plan that considers the investor’s needs, goals, and risk tolerance. For example, an investor might decide to include U.S. stocks, international stocks, and real estate. The second step involves using preferred valuation metrics to identify undervalued segments within those asset classes, ensuring that investments are made at good prices. Taylor suggests tilting the portfolio towards undervalued assets, such as small-cap value stocks, while potentially reducing exposure to overvalued segments like large-cap growth stocks.
The final step in the process is identifying and implementing the portfolio holdings. Investors should choose between individual stocks, mutual funds, ETFs, or a combination of these, aiming to achieve desired exposure to selected asset classes at the lowest cost. Taylor points out that while this approach naturally includes dividend-paying stocks, the dividend yield is irrelevant during the construction process. The emphasis is on building a portfolio that aligns with long-term financial goals and offers a total return rather than merely focusing on yield.
We also introduce the concept of total return, stressing its importance over solely focusing on dividend yield. Total return includes dividends, interest, and capital gains, providing a more comprehensive view of an investment’s performance.
We also provide some historical context highlighting the shift towards total return in the investment world and how this approach better aligns with long-term financial planning.
Performance of Dividend Strategies (12:30)
Taylor shares his analysis of dividend-focused funds, comparing their performance to the S&P 500. He explains that he reviewed 17 open-end dividend-focused funds that have existed since January 1, 1995. Of these funds, 15, or roughly 88%, underperformed the Vanguard S&P 500 Fund through March 31st of the current year. Taylor notes that while these funds may have higher dividends on paper, their total return is typically much lower than the broad market.
Not only did Taylor find that these dividend-focused funds underperformed, but it’s worth noting that the funds studied had the benefit of survivorship bias. Many funds fail or merge with others, which skews the perception of their performance. Despite this bias, the success rate of dividend-focused funds is comparable to that of traditional actively managed funds, where 80-90% underperform passive broad-based indexes. This analysis provides a sobering look at the reality of dividend-focused investment strategies, emphasizing the importance of considering total return over dividend yield alone.
Understanding Buybacks and Tax Implications (17:30)
Stock buybacks involve companies purchasing their stock on the open market, which can be a more flexible option than paying dividends. Companies can announce buybacks and execute them without the same market penalties that come with cutting dividends.
Buybacks became more common after the SEC allowed them in the 1980s, changing the landscape of corporate finance. Buybacks and dividends are neither inherently good nor bad. Instead, they should be thought of as options available for utilizing excess profits or tools companies used based on their financial situation.
It’s worth noting that dividends are subject to dividend tax rates, which can create a tax liability for investors, even if the dividends are reinvested. In contrast, stock buybacks do not result in immediate taxation, as the capital appreciation is not taxed until the stock is sold. Depending on an investor’s tax bracket, the tax effect of dividends can reduce annual returns by up to 1.5% per year, underscoring the importance of tax considerations when evaluating dividend-focused investments.
Retirement Income Strategies and Aligning Investments with Goals (22:15)
Taylor discusses various strategies for creating retirement income, emphasizing the importance of aligning investment choices with personal goals. He explains that many investors are tempted to target high-yield investments to generate income, but this approach can lead to a misalignment with their risk tolerance and long-term goals. Taylor advocates for a total return approach, where a well-constructed portfolio provides a mix of dividends, interest, and capital gains, which are then systematically withdrawn to create a retirement paycheck.
We also discuss the importance of focusing on overall investment goals rather than getting fixated on income. They highlight that investors should consider their long-term objectives, such as leaving a sizable tax-free inheritance for their children, which may not align with a high-yield investment strategy.
Resources:
- Retirement Podcast Network
- Dividend Investing (Part 1): Making Money While You Sleep
- Dividend Investing (Part 2): Three Reasons Why Dividend Strategies Underperform
- Dividend Investing (Part 3): A More “Flexible” Dividend Strategy
- Dividend Investing (Part 4): Answering Top Listener Questions
The Long Term Investor audio is edited by the team at The Podcast Consultant
Submit Your Question For the Podcast
Do you have a financial or investing question you want answered? Submit your question through the “Ask Me Anything” form at the bottom of my podcast page.
Support the Show
Thank you for being a listener to The Long Term Investor Podcast. If you’d like to help spread the word and help other listeners find the show, please click here to leave a review.
I read every single one and appreciate you taking the time to let me know what you think.
Free Financial Assessment
Do you want to make smart decisions with your money? Discover your biggest opportunities in just a few questions with my Financial Wellness Assessment.
