Nancy Graham September 7, 2017 Personal Wealth Demystifying Dividend-Paying Stocks Oh, the mental-accounting tricks we play! “I spent extra time on the treadmill today. So, yes, please, I’ll have that pie à la mode.” Sometimes, small self-deceptions work out fine – like if I get to the gym by imagining my favorite dessert. Unfortunately, in investing, not all mental-accounting tricks add up as effectively. Here’s one I often hear: “Why don’t I load up on dividend-paying stocks? I can then spend the payouts as I please, right?” It’s convenient to think of dividends as being free, “extra” money. Too bad it’s just not true. In today’s “No Dumb Questions,” let’s talk about how dividend-paying stocks really work, and why there are wiser ways to spend and invest your total wealth. Dividend-paying stocks It’s common to mentally account for dividend payouts as if they’re found money that leaves your principal untouched. That’s why I see many investors turning to them to create an income stream. “I’ll buy a bunch,” or so the logic goes, “and live off the ‘extra’ dividends.” In reality, I think we all know that there’s no such thing as “extra” money being handed out on Bay Street! The money that spins off from the dividend-paying stocks is just like any other returns being paid out on your investments: There are risks, costs and trade-offs, even if they’re not as super-obvious. So here’s how dividend stocks really work. Bottom line, those dividends don’t grow on trees. They have to come from somewhere. That “somewhere” is the company’s profits or capital reserves … in other words, from the dollars you and the rest of your fellow shareholders have invested in that company. As a MoneySense article entitled “The income illusion” describes it: “If a company pays you a $1,000 cash dividend, it must be worth $1,000 less than it was before. That’s why you’ll often see a company’s share price decline a few days before an announced dividend is paid.” There is no such thing… as free pie If that’s too technical, think of it like that pie I mentioned in my intro. If you want to reduce your total calorie-count, you can take a smaller slice … or you can remove the ice cream. When taking income out of your portfolio, you can take $1,000 in dividends, or you can take $1,000 of principal. Either way, you’re spending $1,000 of your money. Even if you sort of already knew those payouts weren’t entirely free, I could see how they still might appeal as a convenient way to figure out what to spend and what to invest in retirement. But here’s the thing: If you prioritize dividend-earning stocks, you’re automatically downplaying other evidence-based strategies that I believe better reflect your interests as an investor. Think of it as one of those “horse-before-the-cart” things. Of course you want a prudent way to create an income stream when the time comes … and I help folks with that all the time. But that’s the cart. The work horse is about positioning your money to earn as much as it can with the least amount of risk. That way, you stand the best chance to have enough to withdraw to begin with. As I’ve covered in past videos, whether investing toward retirement, in retirement or at any other point along the way, there’s ample academic evidence suggesting best-practice tactics. The gist is to build a low-cost, globally diversified portfolio that reflects your personal goals and risk tolerances … and to stick with that portfolio through thick and thin. The more you instead get caught up in chasing dividend-paying stocks, the harder it becomes to keep your wealth-management horse up front, where it belongs. Two researchers from the University of Chicago and the University of Southern California also recently found that investors who load up on dividend-paying stocks tend to incur unnecessary market-timing costs, in another classic tale of supply and demand. When a stock is paying out high dividends, dividend-chasing investors tend to flock to those stocks. The result? As you might expect, the researchers found that share prices rose and dividend yields fell. “The free dividend fallacy could be costing you,” they observed. If you think of it that way, you should be less likely to want to hitch your retirement wealth to a dividend-paying strategy. Have you got other questions about spending and investing in retirement? Send them my way. I’m not retiring anytime soon! Share: Facebook Twitter LinkedIn Email CIRO Advisor Report
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