Being Indifferent … to Dividends
Dividends and Dates
When I worked at a discount brokerage, I routinely fielded questions about dividends, in particular, the record date and the ex-dividend date (often abbreviated as “ex-date”). Investors would often get confused by these two dates and the impact they would have on their ability to receive the dividend.
Let’s use RY, the Royal Bank of Canada, as an example. RY is currently the largest company listed on the Toronto Stock Exchange and is also a prominent dividend payer. Their upcoming dividend is scheduled to be paid on November 24. The ex-date for this particular dividend is October 25, which is a Tuesday. This means that if you want to receive the dividend, you need to have completed your buy order by Monday, October 24, or earlier.
These dates also require an understanding of something known as settlement or the settlement date. In 2017, settlement was set at T+2. This means the Trade date plus two business days. In other words, you become the official owner of record two business days after the trade is made. Knowing this and looking at the dates for RY, since an investor needs to have bought the stock by Monday, October 24, the record date that RY’s board of directors had set was Wednesday, October 26, the day after the ex-date.
If this is not altogether clear, consider the perspective of someone who wants to sell RY but also wants to receive the November 24 dividend. That investor wants to be the owner of record so RY cannot be sold any earlier than the ex-date. If sold on Tuesday or later, RY is sold ex-dividend, that is without the new owner being entitled to the November 24 dividend. If sold on Monday or earlier, the investor has also sold the right to the dividend to the buyer.
Dividends are Irrelevant to the Value You Receive
There is often a flurry of trading going on around the ex-dates of dividend-paying stocks. People want to get that dividend. Many investors focus their strategy on investing specifically for dividends. This is largely an issue of investor psychology, however, because we like to see that money coming into our investment accounts. I say “we” because even though I know that I should be indifferent to dividends, I still like to see that money pop in every quarter. I mentioned that I worked at a discount broker. That broker was owned by one of the big banks and one of the compensation programs I participated in was a stock purchase plan, in which I agreed to have a portion of my pay deducted to invest in the stock of the company. This amount was matched to about the 50% level of what I purchased. Over time I have whittled down the number of shares I own but it still pays a significant dividend. There are a few other stocks I own that pay dividends, stocks I bought when I was in my dividend investing phase.
I was a less sophisticated investor at that time, though. Let’s consider the stock of two companies, identical in all respects except that one pays a dividend and the other does not. What happens on the ex-date for Stock D, the stock that pays the dividend, versus Stock N, the stock that does not pay the dividend?
Both Stock D and Stock N are priced at $100 per share. Stock D pays a quarterly dividend of $1 for a total of $4. That works out to a 4% dividend on an annual basis. What happens to Stock D on the ex-date?
The stock price drops on the ex-date. Why? If you sell the stock to somebody else on the ex-date or later, they are not going to receive the upcoming dividend. All things equal, that one share of stock is now worth $1 less than it was the day before. You got your $1.00 plus you have the stock, now worth $99.00. Net effect: no change. If Stock D followed the same schedule as RY above, then on Tuesday morning, October 25, before the market opens, its closing stock price will be exactly $1 lower than it was documented to have been on Monday afternoon.
Stock N, however, since it does not pay a dividend, will not have ex-dates so there will not be any quarterly adjustments to its price. Both Stock D and Stock N will, of course, be impacted by normal movements of the market and their respective idiosyncratic changes.
Don’t Count on Being Paid While You Wait
Dividends are not guaranteed. Companies can and do cut dividends. During the Great Financial Crisis (GFC), when the world’s stock markets tumbled precipitously from mid-2008 to March 2009, many companies reduced their dividends, and several more eliminated them altogether. Sure, some companies may continue paying dividends even when they lose money in a given year, even if it means borrowing sometimes, but that is not a sustainable arrangement.
Dividend Investing Negatively Impacts Portfolio Diversification
In the licensing textbooks that I read near the beginning of my career, there were arguments made that 20 to 30 stocks was plenty to achieve an acceptable level of diversification. As more research has gone into the value of diversification, the more it became understood that a selection of that size exposed investors to significant idiosyncratic risk. An active investment strategy by professional portfolio managers may very well choose that approach, but for the average individual investor, without the resources of an asset management company, those risks are unlikely to be compensated. Only about 50% of the world’s investable stocks pay dividends, so that means a dividend-focused investor is cutting their investable universe in half.
In addition, because Canada offers tax incentives for domestic dividends over foreign dividends, that fact tends to drive dividend investors toward an even narrower range of stocks that they deem eligible for investing.
Canada’s stock market is not very diverse, with nearly one-third devoted to financial services, another 18 percent to energy, 13 percent to industrials, and about 11 percent to basic materials. The Canadian Dividend Aristocrats index reduces financial services, energy, and industrials somewhat, but bumps real estate and utilities up to 13 percent each. If you were to compare these figures to an index that seeks to capture the whole world, you would find that neither the broad Canadian index nor the narrower dividend-focused index has comparable exposure to technology, healthcare, or consumer cyclicals. And while dividend investors tend to overemphasize real estate and utilities, they are relatively minor players in the world’s stock markets, at under 4 percent each.
Dividend Investing Tends Toward Tax Inefficiency
Forced to Receive Income Even if You Don’t Need It
Dividend investors like to receive that regular income, but if you are investing in a non-registered account, and many investors like to locate their Canadian dividend-paying stocks in a non-registered account because of the perceived tax benefits, then you are going to have more taxable income than you may need. This is especially the case when you are in the accumulation phase of your investing life. You will want to reinvest the dividends, but you will be forced to pay tax on them regardless of whether you use them for income.
Tracking the Adjusted Cost Base Can Be a Hassle
Investors with dividends often take advantage of Dividend ReInvestment Programs or DRIPs, a situation in which the dividends are automatically reinvested in additional shares of the same stock that paid the dividend. First, these are typically only done in whole shares so 100% of your dividend is not reinvested. Second, you have to document these reinvestments as they add to the Adjusted Cost Base or ACB of the position. Investment firms have greater responsibilities to document this accurately, but it still behooves investors to keep track of these numbers themselves.
Tax Incentives on Domestic Dividends Tend to Reinforce Lack of Diversification
As noted above, there are tax incentives for eligible Canadian dividends. There is a “gross-up and tax credit” system. Dividends are paid out of after-tax profits, so the gross-up step is intended to reflect the profits paid out in dividends on a pre-tax basis. Then, the tax credit is applied to reflect the tax that the corporation has already paid. While the net effect may result in less tax being paid, one of the negative impacts may be that your government benefits are reduced. For example, the grossed-up dividend may boost your taxable income in retirement to the point that you experience the dreaded OAS “clawback.”
…And Frankly, the Tax Incentive May Be a Mirage
As noted above, the gross-up and tax credit system is supposed to reflect the pre-tax profits of the company and then the tax credit compensates you, the investor, for the tax that the corporation has already paid. The impact of these two moves may not put you in any better position than if the company was doing equally well but was not paying out dividends. Especially when you are accumulating assets, you could just let the company grow, deferring tax all along the way. Then, if you need money, which may not be the case until retirement, you can sell a portion of your shares, and pay tax on the capital gains, which are taxed at only half the rate of regular income.
Be Indifferent to Dividends
I like to suggest that an investor be indifferent to dividends. There is no doubt that they play a significant role in the returns that one receives from investing, but most will do better by investing without giving special consideration to dividends.
If you would like to learn more about the fallacies of focusing on dividends for investing, watch some of Ben Felix’s Common Sense Investing videos on YouTube. Here are four such videos on the topic.
This is the 166th blog post for Russ Writes, first published on 2022-09-26.
Click here to contact me for an appointment.
You may be interested in a half-hour no-cost, no-obligation financial planning conversation with me. Click here to sign up for a free session of FinPlan30.
Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.