Search “dividend stocks” and Google will return over fifty million results in less than half of a second. I got a good laugh out of some of the headlines:
- Get Rich Slowly Scheme for Everyone
- Double Your Passive Income with This Dividend Investment Strategy
- The $1382 Per Month Dividend Strategy
There is an abundance of conflicting information on dividend investing and today we are breaking it all down for you.
Dividend stocks have long been referred to as a solid investment strategy. Not because of their historical performance or tax efficiency but because they tell a good story. Unfortunately, when you really dig down into the numbers and compare dividend investing to the alternatives, the story falls apart.
In today’s episode we’re going to take a deep dive into the world of dividend stocks and explore the following:
- What a dividend is
- Why people love dividend paying stocks so much
- 5 reasons most people should avoid dividend paying stocks
- Smarter, alternative ways to create an income stream without dividend stocks
If you want to understand the world of dividends (in plain English!) and learn how to generate an income stream the right way, you’re going to want to check out today’s episode.
How to Listen to Today’s Episode
Episode Links & Resources:
0:47 – Welcome and introduction to dividend-paying stocks
0:59 – Making fun of the media
1:38 – Making fun of the media
3:04 – Making fun of the media
4:23 – What is a dividend
7:27 – Companies that re-invest their capital underperform companies that buy back their own shares. Another great article on the topic HERE.
9:35 – Why do people invest in dividend-paying stocks to begin with
13:24 – 5 reasons you should stay away from dividend-paying stocks [Define Financial Blog Post]
13:32 – #1 – Historical performance, current valuations, and interest rate environment
- 14:40 – There have been sixteen rising interest rate periods in the U.S. since 1927. During these time periods, Patrick O’Shaughnessy found that the high yielding dividend bucket underperformed the broad stock market by 2.6% compounded.
16:50 – #2 – Funds that focus on dividend-paying stocks are generally more expensive than broad-based index funds
19:42 – #3 – You’re not properly diversified when you only own dividend-paying stocks
21:34 – #4 – Investing in dividend-paying stocks leaves you susceptible to being part of a bubble or mania
25:58 – #5 – Dividends are subject to double taxation
28:57 – Alternative solution: Total Return Investing
34:47 – Total-return investing: An enduring solution for low yields
Episode Transcription
Dividend Stocks: 5 Reasons to Stay Away
Jon: Taxes are their cost. And when it comes to investing, we want to minimize our costs. So if we can minimize taxes, that means minimizing costs. That means we're going to have more money at the end of the day.
Taylor Schulte: Welcome to Stay Wealthy San Diego. A show for successful professionals doing all the right things with their money and are ready to take their financial plan to the next level. I'm certified financial planner Taylor Schulte, and I'm here to teach you advanced financial planning strategies in plain English.
Taylor Schulte: Alright, today's going to be a fun episode.
Jon: I'm a little anxious. I'm not sure what's happening.
Taylor Schulte: You have no idea what we're talking about today.
Jon: I don't. Should I make some guesses or?
Taylor Schulte: Yeah, let's make some guesses. I'll give you one hint. I was doing some research for the show, typed some stuff into Google, and here's one headline that came up. A headline from CNBC that says A get rich slowly scheme for everyone.
Jon: So buy, hold, index investing, is that what we're talking about?
Taylor Schulte: Yeah, the complete opposite. No, today we're talking about dividend stocks.
Jon: Okay.
Taylor Schulte: All right. So I typed in dividend investing into Google. How many results do you think came up?
Jon: Is there a number bigger than infinity?
Taylor Schulte: So I had 53 million results show up in half of a second. Nice. So there's a lot of information out there on dividend-paying stocks. More so today probably than ever given the current interest rate environment. And we'll certainly talk about some of that.
But here's some of the other headlines that came up that I just thought were just funny and just kind of sucked people into this stuff. One of them from nasdaq.com. Double Your Passive Income with this Dividend Investment Strategy.
Jon: What could possibly go wrong?
Taylor Schulte: Another funny one, the $1,382 per month dividend strategy.
Jon: Yeah, I think they forgot to think about percentages in that argument.
Taylor Schulte: That is true. So we are going to dive into the world of dividend investing today. Specifically, we're going to talk about five reasons why we think you should stay away.
And then if generating income is important to you, maybe aligns with your goals or maybe you're approaching retirement or maybe you're in retirement and you need an income stream, we're going to talk about how you can properly do that and why investing in dividend stocks alone probably isn't the solution.
Real quick, last couple of shows we recorded. I noticed that we refer a lot to the show notes and most people probably don't know where to find the show notes. So as we say that throughout the show, if there's something that you want to look up, you want to read about, you can always find the show notes by going to staywealthysandiego.com/whatever the episode number is. So today, the episode number is 25, so go to staywealthysandiego.com/25 and you'll have all the resources right there for you.
Jon: So I imagine in the show notes, it's going to be our blog post on dividend investing, which has that little graphic of that guy terrified. I love that little graphic.
Taylor Schulte: Yeah, you are good at making those graphics
Jon: Sometimes. I'm getting better.
Taylor Schulte: Alright, so dividend paying stocks. So we we're going to hit three things today. Number one, why do people buy dividend stocks to begin with? Why are they attracted to them? Why are they so popular?
Two, I already mentioned this. We're going to talk about five reasons why we think most people should stay away from them.
And then three, how to create an income stream the right way. So if you do need income, if you're at that stage in your life or it aligns with your goals, how to properly create an income stream without taking too much risk, make sure you stay until the end.
We're going to share a free resource with you that will be linked up in the show notes as well. It'll talk about creating this income stream, how to do it if you're a do-it-yourself type investor. This'll have everything you need, but we'll talk a little bit more about that towards the end.
So Jon, you've had no time to prep, but I know this topic well before we talk about why people buy it and why to stay away, let's just talk about what a dividend is.
Jon: Sure. Great question and probably a good way to set the base for this podcast. So imagine you own a share of Apple. Now you're part owner of the company and because you're part owner of the company now you're entitled to the benefits of ownership. And Apple's decided, hey, we have a lot of cash. We've sold a lot of iPhones for outrageous prices, and people are still buying them even though they're really expensive.
So now we have all this cash, let's reward our investors. So if you own a share of Apple stock, apple is going to give you a little bit of cash from their giant massive mountain of cash that they're sitting on and that cash they give you, that is the dividend, that's the cash payment and that represents profit that the business is generated.
Taylor Schulte: So companies like Apple sitting on mountains of cash, or maybe they're not, but companies can return money to their shareholders in a few different ways. They can do it in the form of a dividend, which you just spoke about, which is usually just a cash payment to you, the investor.
It usually comes to you quarterly, sometimes monthly, and most people are on some sort of automatic reinvestment program. Dividend hits their account and then it just gets reinvested right back into Apple or whatever stock or mutual fund they own. But companies can also buy back their own stock share buybacks.
Surprisingly, doing research for this show, I learned that over half of company cash flows are distributed to investors through buybacks. Interesting. Yeah, so it's a big number, but buybacks have been a topic in the news lately. You can kind of Google around and read more about it.
Maybe we'll have a show dedicated to that in the future. But essentially a company buys back their own shares. It reduces the number of outstanding shares that are out there and the remaining investors, if you still own shares of that stock, you have a larger piece of corporate profit.
So buybacks are actually a pretty good thing. Absolutely. But they've definitely taken a hit a little bit in the media lately and whatnot. So companies can return money to shareholders via dividends, share buybacks, and then they can also reinvest back into the company. Apple thinks that the money is better used to reinvest into research and development and new products and things like that so they can choose to just hold that cash and reinvest it back into the company.
Jon: Berkshire is a good example of that. They did one dividend distribution in the history of the firm and there is a joke that it was by accident. Apparently Warren Buffett was in the bathroom when it happened. And the reason is because Buffett believes, and probably rightly so, that he can find better investment opportunities with cash, then we're here to give that cash to the companies, to owners of Berkshire and being Warren Buffett, he's probably right.
Taylor Schulte: What's interesting too is I've got to find the data to support this where we're going to have to cut this out, but I believe that companies that heavily reinvest back into themselves underperform companies that pay dividends or do share buybacks.
Jon: Well, I know, gosh, there's just this compilation of studies and I believe it was Towers Watson or whatever that company's name is, and they looked at the Fama French paper was in there, all the sort of factors that lead to excess return.
And it did show that relative to a larger sample pool that companies that do issue dividends do outperform on average companies that don't. Now, just because dividend-paying companies do better than all companies doesn't mean that it's the best strategy ever, but part of the reason why that is is because those companies have a slight value tilt.
So dividend investing, it's a water-down value tilt. If you want full value, you'd outperform dividend investing. And of course the broader market generally.
Taylor Schulte: And you actually kind of made my next point, I wanted to clarify that. Investing in dividend stocks, I want to preface this whole thing, investing in dividend stocks as much as we're going to beat up on them today, it's not the worst investment in the world. We could do a whole episode on all these investments that are worse in dividend-paying stocks.
There are periods where high dividend-paying stocks have performed really, really well. But a couple things and you just hit on one of them.
Number one, performance only tells part of the story. We're not taking into consideration risk-adjusted returns, valuations, things like that. So performance only tells part of the story. If your goal is to hit the ball over the fence and swing for the fences and have the highest performing investment, that's a different conversation.
But two, dividend investing on the surface kind of looks like value investing. It might be called a dividend strategy, but you start digging into the weeds and it's really more of a value tilt. And we both know how powerful the value premium is and how beneficial that is to a portfolio. So it might look like a dividend strategy, but actually it's a value strategy.
Jon: Yeah, it's a value light strategy. You'd be better off going full value, but it's certainly better than the broader market on average.
Taylor Schulte: Alright, so why do people buy dividend stocks to begin with? Why are they so popular?
Jon: Yeah, I'm going to go to the article title. You referenced a thousand dollars a month or whatever. And the reason why is for the same reason that blog posts or whatever that article title makes no sense is because you're looking at the wrong thing. You're not looking at the numbers, which is literally what investing is all about.
It's just the numbers. It's how much return do you have at the end of the day relative to your risk. It's just a number relative to the emotional aspect of it. So emotional, if someone hears a thousand dollars a month, it's like, well, I want a thousand dollars a month.
Sure, yeah, maybe in a vacuum that sounds nice, but if you're investing a hundred billion to get a thousand dollars a month, that's really not a great investment return. It's the same reason why people like dividend stocks is because they get this paycheck. Maybe they get a check from their investment account and then they can cash that, or they see the cash balance and their account growing and they just like that cash.
It's an emotional thing. They haven't really sat down with the spreadsheet and been like, oh yeah, well it's nice to get these cash distributions, taxes are killing me and I would've been better off with a low-cost index fund anyway.
Taylor Schulte: Maybe said another way. Dividends, they tell a good story, right? $1,382 per month dividend strategy. It tells a good story and people are attracted to stories. We know how well stories sell and financial advisors and mutual fund companies have learned to capitalize on this.
So telling a good story, people getting emotional, but I'm going to throw another couple of reasons at you and tell me what you think. One of the big reasons people are attracted to dividend-paying stocks is they need income. They need an income stream for whatever reason, again, maybe retirement.
And they hear that dividend stocks paying income stream and those two things kind of match up and they're like, I'm going to buy dividend stocks. So the need for income, also the current interest rate environment, I mean, we all know that cash in the bank is yielding close to nothing.
And so that's driven a lot of investors to go out and search for yield. They want to higher yield than half a percent or a percent whatever they're getting in their checking accounts and savings accounts. And so they see these dividend-paying stocks that are paying 3%, 4%, 6%, and they think that's maybe a cash alternative or a way to generate some income in a low-interest rate environment. A little bit scary.
What else? I think you kind of hit it. Receiving a cash distribution, like getting a check, getting a cash payment from Apple. It seems like a good thing. Why wouldn't I take that? Apple's paying me two 3% dividend, I'll take that all day long.
So it just kind of seems like a positive thing on the surface. And then lastly, what I think is it's kind of investing in what you know, it's a lot of popular dividend-paying stocks are just companies by name, your Coca-Colas, your Johnson and Johnson, your GEs. And these are companies that our parents and grandparents talk to us about and just kind of feel comfortable buying them.
Jon: And to your point about getting the check in the mail, there's certainly this unmeasurable value in getting just that. God, there's a client, before I was working with her, she was really excited about these tax-free municipal bond distributions. She was just excited they were tax-free.
Now, ignoring the fact that you could have gotten more money after taxes on other investments, that really wasn't as interesting as, but this is tax-free. It's definitely the story part of it that just makes it so compelling.
Taylor Schulte: Absolutely. So for all these reasons and more that we're probably missing, people are really attracted to dividend-paying stocks more so today than ever. And that's the reason that we wrote the blog post and that's the reason we're talking about it today.
So with that out of the way, we're going to talk about five reasons why we think you should stay away from dividend-paying stocks.
The first reason is historical performance. Historically, dividend pain stocks, again, they're not the worst investment in the world. We could find a lot worse of an investment than dividend-paying stocks, but historically they haven't done as well as some other simple low-cost strategies. Things like value investing, focusing on shareholder yield, low dividend payout ratios, those have typically performed better over long periods of time.
Jon: Small capitalization as well. And these strategies, they're not only higher returning, but they're higher returning given the risk involved. So for the risk you're taking on, you're getting an even better return with some of these small-value strategies relative to dividend investing.
Taylor Schulte: So it's like I said earlier, performance only tells part of the story. We want to look at risk-adjusted returns and then we'll dive into this a little bit. Want to talk about after-tax returns too. Another maybe potential headwind in the performance department for dividend-paying stocks.
A colleague of ours, Patrick O'Shaughnessy, did some research and he found that in history, since 1927 there have been 16 periods of rising rates in the United States. So we're looking at history, it's not necessarily an indication of the future. Nobody knows the future. But just kind of an interesting factoid here.
So since 1927, there's been 16 periods of rising rates in the United States. And during those periods the stock market averaged about 11%. Okay? Now there's some wide dispersion there where we had positive performance of almost 41% and negative performance of almost 46%. So a huge range there.
But if you stayed the course and didn't panic and didn't get emotional, you had a pretty decent return during these rising rate periods. So then he compared that to the high-yielding dividend bucket and how that compared, and it underperformed by two and a half percent compounded during that same time period.
So some folks have speculated that interest rates have been low for so long that they have nowhere to go but up. Look, we don't know where interest rates are going. They are historically low. Could they stay low for a long time? Sure. Might they start to go up maybe. And if they do, maybe that's a potential headwind for dividend pain stocks in the future.
Jon: Yeah. You mentioned something that I want to circle back to because if you're not a giant nerd, you may have missed it, but Taylor mentioned there's a 2% difference return per year and that maybe 2% per year doesn't sound like a lot, but that is huge. That's huge.
If you can increase your investment return by 2% per year compounded over multiple years, then result is just, it's going to blow your mind. The difference is going to be so huge.
Taylor Schulte: So historical performance, not as great as some other smarter lower cost, more tax efficient strategies that are out there. So that's reason number one, why we think for most people, just focusing on dividend paying stocks probably isn't the smartest way to invest your hard-earned money.
Reason number two is cost. When you focus on just dividend-paying companies, let's say you want to go out and buy a mutual fund that's made up of dividend-paying companies, it's usually more expensive than just a broad-based index fund. You're focusing on one specific sector. The fund company has to take some extra measures to construct this thing and put it together and sells a little bit better, got a good story.
And so it ends up being a little bit more expensive. So we looked at just two general funds that are out there, no particular reason, they just kind of prove the point. But there's an iShares S&P total US stock market fund. You essentially just get access to the entire US stock market, broad base, nothing special. The expense ratio is 0.03% or three basis points, which is almost free, really.
Jon: Yes. It's nothing. It's nothing.
Taylor Schulte: It's almost nothing. The iShares select dividend ETF, notice how much better that name is too. The select dividend ETF versus the core S&P total US Stock Market.
Jon: It sounds very fancy. I mean now that you mention it, I kind of want it.
Taylor Schulte: Yeah. Hey, it tells a good story. So the iShare select dividend, ETF expense ratio 0.39%. So almost 13 times more expensive than that broad-based US boring stock market fund that you and I would probably prefer to own.
Jon: Yeah, at that point, I mean you're closer to half a percent than not. It's just money that I wouldn't want to pay. And the other thing that you mentioned that I also want to stress is that when you focus on dividend investing, human energy and attention span, everything else is finite.
So when you focus on one thing, you lose focus on another. So if you focus on dividend investing, it means they're going to lose focus on cost. And cost is just so critical to investment success. You have to be absolutely obsessed with cost.
If you're going to be a successful investor and given the limited capacity of the human brain, you can only focus on so much. So if I'm going to focus on one thing, it's going to be cost and not dividends.
Taylor Schulte: And let's point out the example we just gave is for those people that are cost-conscious, right? If you're using an iShares ETF, you probably know a little bit about investing and the cost associated because iShares ETFs are generally cheaper than some of these expensive active mutual funds that are out there.
So the price difference could be way worse. If you're in a company 401k plan and there's a dividend mutual fund in there that's charging 1.5% or 2% per year, compare that to 0.39% or 0.03%, you could be paying a lot, a lot more.
Jon: Absolutely.
Taylor Schulte: So the third reason that we suggest maybe staying away from dividend-paying stocks is diversification. If we're going to just invest in dividend-paying stocks, we're doing just the opposite of that. We're putting all of our eggs in one basket. That's like me saying, I'm just going to go buy international stocks.
That's just one sector of the entire world. So just investing in dividend-paying stocks is essentially the same thing, right?
Jon: And usually a lot of these dividend stocks are rather, the funds are going to be US-based. So you're really narrowing your investment pool into just large US companies, which isn't the best strategy in terms of risk reduction. I mentioned this on the last podcast. The S&P didn't do great for 10 years, but all these other asset classes did small value international emerging markets. You need diversification. It's just it's investing 101.
Taylor Schulte: Yep, yep. And I mean, a lot of people associate investing dividend-paying stocks with safety, right? Because it pays a dividend, it has an income stream because the company is Johnson and Johnson or GE, and they've been around forever, they think, well, it must be a safe investment. But a lot of these, they can be safe until they're not safe.
Jon: And just because Johnson and Johnson has great financials and it's not going anywhere, doesn't mean that you're not paying a ridiculous price for it and that it's in a bubble alongside every other dividend investing company. And that means your principal's at risk. The amount that you originally put in is at risk.
So if the stock is selling for a hundred dollars and you get a $2 dividend and you're happy with that, well then when dividend investing runs out of fashion and now that share price is down at 50, yeah, maybe you're still getting your $2 dividend, but the original amount of money you put in just got cut in half.
Taylor Schulte: Alright, reason number four, performance chasing. Alright, so this is a good one. Let's stick here for a little bit. We talked about the low-interest rate environment, pushing a lot of investors into dividend-paying stocks, the money markets, their savings accounts, their checking accounts.
They're not paying hardly anything on people's cash. And so they've started to look in other spaces to try and get an interest rate on their cash. So a lot of people have been pushed into dividend-paying stocks or things that are similar. Mutual fund companies have designed products around these things and they're selling them like crazy.
Again, they tell a good story. What happens when a bunch of investors come in and buy up the same asset class?
Jon: It's foolproof. Nothing will ever go wrong if you do that. No. You're just, oh man, you're buying into a bubble. And what do bubbles do? They pop eventually. That's just what happens. We've seen it in real estate, and I think I touched on this on a previous podcast. We had a dividend investing bubble several decades back with a nifty 50.
It's big blue chip companies, which people are pouring all their money into because they just got over the last bubble where they're investing in some sort of nonsense. And therefore people decided, oh, I'm only going to invest in blue chip now. And then blue chip companies went into a bubble.
And of course that popped eventually too. You're not the only one doing dividend investing. Everyone else, and their grandmother is doing it right now. And as interest rates continue to increase, people are going to start running out of dividend investing, which means, again, that a hundred dollars you put in now could get cut to 50.
Taylor Schulte: Because investors have just been buying dividend stocks and dividend funds like crazy, it's pushed up the valuations. I don't have any specific numbers to share, but in general, dividend stocks have become more expensive than stocks that are out of favor or just broad stock market indexes.
Jon: Yeah, there's certainly more expensive than their historical average. There's no doubt about that.
Taylor Schulte: Exactly. The more expensive they are, the more overvalued they become. And what does that mean? It means the more likely they are to have lower returns in the future. Maybe not tomorrow, maybe not five years from now. We don't have a crystal ball, but the odds are that they will have a lower return in the future.
Jon: Yeah absolutely. On a long enough timeline, if you pay too much for something, future returns going forward are going to be smaller. It's just math. There's no way around it. You overpay, you're not going to get a good value.
Taylor Schulte: And then remember, and I think you found the article, gosh, a couple years ago, maybe three years ago, dividend-paying stocks became so popular or are so popular and in such high demand that Vanguard actually closed the doors on one of its dividend mutual funds. It couldn't take any more money into this thing because investors max the thing out.
So if that doesn't signal that, maybe I don't want to call it a bubble maybe, but that these things are just getting overvalued. They're getting a little frothy and maybe it's time to be a little careful. I don't know what other example to share.
Jon: Maybe bubble isn't the right word. Let's just call it a mania instead.
Taylor Schulte: There you go. A mania. And we've seen a lot of them. We've seen the real estate mania bubble, we've seen gold go through this. You mentioned the nifty 50, which is the bull market back in the seventies, 50 large-cap stocks that everyone kind of knew by name and then what happened? They all crashed and burned.
So just keep an eye on this stuff, on these trends. Be careful not to chase performance. And again, all these reasons we're giving you today, we're going to want to consolidate these all together.
So we're not avoiding dividend-paying stocks just because of performance chasing or just because of diversification or just because of these are all kind of combined. All these things combined is kind of the one big reason why we just don't think it's the best investment.
Jon: And on that note, to be clear, we're not saying don't buy dividend stocks, but just hold it in proportion as you would the rest of your other investments.
Taylor Schulte: Very good point. Yeah. Just because a stock or a fund pays a dividend doesn't mean it's just time to get rid of it, right? That's just one factor to look at when you're looking at a portfolio.
Jon: Exactly. Just don't focus on dividend investing. We want to hold all the stocks. We want diversification.
Taylor Schulte: Alright, our last reason, which I think is probably the most important is taxes. Dividends are a victim of double taxation. So a company pays its dividends to you with after-tax earnings. So they've paid taxes, then they pay the dividend out to you and then you get taxed on that dividend that year.
So you can't defer those taxes that year. The year that they pay you that dividend, you're paying taxes on it. I was thinking it's kind of like you work for a living, you get your paycheck, your taxes get taken out of your paycheck, and then you give your kid an allowance and then the IRS comes knocking on the door and wants to take some taxes out of your kid's allowance. It's kind of the thing.
Jon: Yeah, company makes money. They have profitability that those profits are taxed now with the after-tax profits. They give them to investors and investors get taxed once again.
Taylor Schulte: So dividends are not the most tax-efficient way of distributing capital. So it's one thing to consider when you do hold dividend-paying stocks. Is the tax drag on your portfolio?
Jon: Absolutely. Taxes are their cost. And when it comes to investing, we want to minimize our costs. So if we can minimize taxes, that means minimizing costs, that means we're going to have more money at the end of the day.
Taylor Schulte: Anything else on taxes?
Jon: I'll add that maybe some of you have every single penny of your money in a tax deferred account like an IRA or a 401k or a 403B. So you're throwing this argument out the window saying, ah, it doesn't matter to me. I'm not going to pay any taxes on my investments.
Or maybe all your money's going to Roth, but actually there's still a cost because if a company issues a dividend, now that's cash in your account. If you reinvest it now you're going to buy something else. There's a transaction cost for reinvesting that dividend.
So even if there isn't taxes, you're still paying a cost just because of all the moving pieces that need to be moved to reinvest the cash. At the beginning of this episode, we touched on share buybacks being an alternative to dividends and with respect to taxes, share buybacks are a much better way to go because you have capital appreciation.
That is the value of your stock rises, but there's no immediate tax consequence for that. So share buybacks a lot better than dividends because no immediate tax consequences.
Taylor Schulte: And maybe we'll just finish this tax segment by just saying, if you're going to hold dividend paying stocks, you just have to have 'em important to you. I think we would just say hold them in a tax-deferred account, put them in an IRA account, and then use your taxable investment account for some other strategies that are a little bit more tax-efficient.
It's not our favorite solution that are better solutions that are out there, but if you just need to hold your dividend-paying stocks, consider putting them in a tax advantage account.
Alright, so we've beat up on dividend-paying stocks. We've given you five reasons why we think most people should stay away. If you need an income stream, if that's why you're buying dividend-paying stocks or you just want a smart way of investing your money and dividend-paying stocks aren't the solution, then what is the solution?
And our favorite solution is something that's called total return investing. We'll talk a little bit about that and then we'll share some resources with you as well. When a client or anybody for that matter needs income, they have three choices, they could spend less. We know how hard that is for people, very hard, especially later on in life.
Their habits are, it's hard to change these behaviors so they could spend less, they could reallocate their portfolio to higher-yielding investments, which we talked about people getting chased out of safe money markets and savings accounts and into these maybe more risky investments or three they could spend from the total returns of their portfolio.
So you can kind of create your own dividend by selling chunks of your diversified portfolio maybe annually or semi-annually in order to produce that income stream for you. Given that, like I said, it's really hard for people to change their behavior and spend less money, that's a real challenge that we see.
We definitely don't like the idea of people chasing into these higher-yielding investments. So we prefer point number three, which is a total return approach where you're kind of creating that income stream by selling chunks of your portfolio, your diversified portfolio, and keeping that all intact and maintaining diversification.
Jon: It's maybe a challenging principle for someone to wrap their brain around. But imagine you've got two stocks, you've got your dividend stock and you've got your Share buyback stock, right? Your dividend stock, it's selling for $10, it gives you a dividend of $1. Now your account is worth $11 and you're like, great, I'm going to take this $1 and spend it and my life's going to be awesome.
Or you could do the share buyback stock and you buy it for 10, now it's worth 12. Well, now you've got $2 more. You are allowed to sell part of it, as in this scenario, you can sell $1 or $2 and you can enjoy that money and do whatever you want with it. You're allowed to sell a part of your stocks, part of your investment and live your life and enjoy it. It doesn't have to be just the dividends, and that's what total return investing is.
Taylor Schulte: And I think what people kind of fail to realize too is when they're just focused on a certain sector or a certain style like dividend paying stocks, again, they end up taking more risk. So we talked about how they could end up being in an overvalued investment. We talked about the nifty 50 and what happened to those stocks.
So you can end up taking more risk, decreasing tax efficiency in the portfolio. You're going to end up with a less diversified portfolio anyways. And then finally, I think what's most important is an increased chance of failing to meet your long-term goals. We invest for longevity, we want our portfolio to last a long time number.
We're living longer as well, but we want our portfolio to last a long time to provide us with an income stream. And just focusing on income-oriented investments like dividend stocks could cause you to fail short of reaching these long-term goals.
Jon: Absolutely, and again, taxes are part of that. The great thing about having a broader portfolio using total return investing is you can be smarter about your tax management. With dividend investing, you get a tax bill that shows up every quarter. When dividends are paid, there's nothing you can do about it.
So whether you need the dividend cash or not, you're paying taxes. If you do total return investing, you can choose when your taxes show up, and that's going to be a function of when you rebalance or when you decide you need money from the account, you can be a lot more strategic.
And again, if you minimize taxes, which are a cost, your returns are just going to do better.
Taylor Schulte: That's a really good point. I think if we really boiled that point down, it's flexibility, right? Total return investing gives you flexibility. If you're relying on a dividend income stream, again, maybe there's a year where you don't need the dividend, you're getting taxed on it, you don't really need it, you don't have flexibility.
So with total return investing, you have a lot more flexibility with managing your taxes and managing your portfolio. Look, maybe we go through a really tough time. Maybe we go through another recession and your diversified portfolio has lost value. Maybe you're willing to spend less and adjust your lifestyle during that time period.
Take less out of your portfolio, have a smaller tax bill, get through that recession, and then once you're through the other end and you've been a smart, diligent investor, then you can turn that income stream back on and start to sell chunks of your portfolio again. But again, in a concentrated dividend-oriented portfolio, you don't have a lot of choices.
Jon: To add to your point about flexibility. Imagine one year you get an inheritance and now you don't need your dividends. Or rather you don't need a chunk of your portfolio or maybe your sell business a certain year and now you have a lot of cash from that, or maybe you sell a rental property and you don't need money from your portfolio.
Well, if you have a portfolio that's full of dividends, those taxes are going to show up anyway. That cash is going to show up anyway. You don't have that flexibility if all your investments are in dividend stocks.
Taylor Schulte: So if we just put you to sleep and bo you to death with all of that, don't worry. It's online. Vanguard wrote a really, really good paper on this topic. If you just Google Vanguard Total Return Investing, this white paper will show up. It's a nice PDF. You can print it out.
We will also link to it in the show notes again, which can be found at staywealthysandiego.com/25 because this is episode 25, but there's a lot of good resources online about this.
Again, I've repeated myself way too many times in this episode, but the real three reasons why we want to focus on a total return approach and keep costs low in the portfolio is this one, maintain diversification. Super, super important.
Number two, we want to enhance your portfolios. Tax efficiency taxes will just kill you. So we want to be very careful about taxes, especially as we're getting close to retirement, especially as we're in retirement. And even if you're accumulating money in your thirties and forties, taxes are a drag on your portfolio.
And then number three, we want to increase the portfolio's longevity. I mean, we just don't know how long we might need that portfolio. There's a lot of unknowns in the future. So that's really the reason that we want to take this approach. It's backed by a ton of academic research. We're not just throwing spaghetti at the wall here. This stuff really, really works.
Jon: Absolutely. And why do we want diversification to decrease our risk? Why do we want to avoid taxes to decrease our costs? These are just basic rules of investing.
Taylor Schulte: So we hope this is really helpful for you. It's a really important topic. If you look closely, you're going to see dividend-paying stocks all over the place. There are articles everywhere. Again, I had 55 million search results in half of a second on Google. Crazy.
It's just, it's information overload these days. We're trying to boil it down. We're trying to keep it simple. We're trying to give you really smart ways to manage your hard-earned money. If you have any questions, you know where to find us, our email address is podcast@staywealthysandiego.com.
We personally read every email. We will respond to every email. If you have any suggestions for future episodes, if you have any really, really good questions, it may just turn into a future episode. So please, we'd love some feedback. We appreciate all of your support. We're really enjoying this podcast so far, and hope you're as well. Thanks everybody.
Episode Disclaimer: This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.