I recall filling those questionaires provided by financial advisors, asking whether I like more income investing or more growth investing. Initially, I didn’t really understand the question. I told the financial advisor, “you know, I just want to have good return. I don’t really care whether it’s from income investing or from growth investing.” She said I was funny, but I was dead-serious. Now I understand that income investors want to have current interest or dividend income, while growth investors want to grow capital gain. But the underlying assumption by the financial service firms is that both will make money, and you just kind of pick and choose the way of returns. Well, I wish investing is that easy.
I just finished my most complicated tax return last month. I got $11775.91 dividend, of which $10008.58 are qualified dividends. I’m fully utilizing Bush’s dividend tax cut, preserving most dividends as qualifed dividends. For those who are not familiar with the dividend tax cut, a qualified dividend is taxed at 15% or 5%, unlike ordinary dividend which is taxed at marginal income tax bracket which can be as high as 35%. Your holding period must be more than 60 days within the 120 days of ex-dividend date to qualify for the lower dividend tax rate.
How did I receive so many dividends? I definitely didn’t have more than $200K invested in the dividend-paying stocks. 5% of $200K is $10K, but my dividend stocks usually pay out closer to 10% (ranges from 7% to 15%). If you just have $20K invested in such stocks, you would have gotten $2000 to $3000 assuming a 10% to 15% yield. It’s not a lot, but surely beats the paltry 2% local bank yields.
The primary reason that I want to invest in dividend stocks is to reduce the overall volatility of my portfolio. Most people adjust bond allocation to reduce portfolio volatility. However, I have basically zero bonds because they are losers’ bet in an inflationary environment. I believe long term bonds of 10 years or greater are guaranteed to lose money after inflation. Stocks are hedges against inflation, while bonds do the best in a deflationary environment. The dividends of stocks can go up along with inflation, while the interest payout of bonds are fixed.
Trading dividend stocks can be tricky because most of them are interest rate sensitive. I didn’t realize this until I lost almost 20% in a stock when US Federal Reserve began interest rate hiking in 2004. After that, I can pretty much quantify the effect of interest rate on a dividend stock:
yield premium (or risk) = current yield – safest yield (usually as 10-year treasury bond yield).
The yield premium for a given stock is usually fixed but can change gradually. When Fed started to raise interest rate in 2004, the forward expection of safest yield suddenly jumped. Since the yield premium is about the same, it means the current yield must increase, and therefore the stock price had to fall. Let me use an example. If a stock is paying 7%, while 10-year bond is trading at 4%, the yield premium is 3%. Assumes that the expectation of 10-year bond goes from 4% to 5%, the stock should be yielding 8% instead of 7%. Assumes that the stock usually pays out $7 of dividend, and trades at $100 (7% yield). Since the absolute amount of the dividend doesn’t increase immediately, and is still $7, to get to 8% dividend yield on the same stock, the stock needs to fall by 1 – 7% / 8% = 12.5%, to $87.5. At $87.5, a $7 dividend will give you 8% dividend yield.
Once there was a Smith Barney financial advisor who attempted to trick me out of my dividend stocks to be invested with him, and told me that they trade like bonds. Well, yes, he was right, but not right enough. I immediately told him that some of my dividend stocks yield more than 12%, and at a 12% yield, the stock will just fall 7.7% for a 1% interest rise in treasury bond. And if I was getting 12% yield, I wouldn’t care about the 7.7% fall, since I will still net 4.3% positive return.
Most of my dividends come from foreign stocks. Part of the reason is because US stocks simply don’t have good dividends to beat inflation rate on an after-tax basis. The other reason is that dividend payouts in foreign currency will increase in value when $US fall. Furthermore, your capital in foreign stock which is based in foreign currency will also preserve its value when $US falls.
Furthermore, most of my dividend stocks have at least one of the following characteristics:
- The company is growing, and dividends are increasing.
- The company is in an industry that will benefit from inflation directly, such as energy production companies. On the other hand, utility companies such as Edison, which are unable or slow to pass the inflated cost to customers, are not a good bet.
- The company is based in a country with a strong currency, but their products must either have a strong pricing power in the global market, or localized in the local economy. Otherwise, a strong currency will only raise the cost, without a corresponding increase in the revenue.
I will follow up this post with other types of “dividends” which are either legally tax-free, or close to tax-free. Have you ever filed federal tax Form 8271 Investor Reporting of Tax Shelter Registration Number? If not, maybe you have missed out something. Man, is this the secret of wealthy people or what? Receiving cash payout like dividends, but without paying much taxes at all! Finally, I found out about these deals in the last three years.
Readers’ notes: Here is the entire dividend investing series.
- Master Limited Partnership – Great Dividend Savers
- Royalty Trusts – Get Paid Royalties w/o Paying (Much) Taxes
- REIT as an Alternative Dividend Investment
- List of High Yield Dividend Stocks (Up to 18.6%)
- Foreign Taxes Withheld Problem (this is not part of the series, but most likely you will face the same problem.)