"Over the long run [dividends] provide the bulk of equity investors’ returns." Buttonwood, The Economist
There’s a big sell out there about dividends right now. The baby-boom generation is moving into retirement and needs income. Bond yields are low and dividend yields are high by comparison. Everyone wants dividends! As a result so many investment management firms are playing to investor’s needs the only way they know how - by launching high income funds and dividend focused ETFs. In support, reams of classic and modern research papers about the long term outperformance of dividend stocks have been dusted off and despatched. We’ve covered some of those papers in recent pieces on the site, but some highlights from them include claims such as:
- Over 200 years, equities have returned 7.9% annually, 73% of which has been due to dividends and dividend growth.
- Dividend stocks offer downside protection, are low volatility, and provide 90% of the return from stocks in bear markets.
If you believed the hype, you’d surely throw all your money into dividend stocks and sit back and prosper. While that may be a very good strategy according to the research, very few investors have ever been able to achieve these fabled results in the real world. The reasons why are very simple and mostly due to a pair of extremely simple mistakes. Ensuring you don’t make these mistakes in your own investing can at least give your portfolio a higher chance of outperforming over the long run.
1. Not buying dividend stocks in tax-efficient wrappers
It’s so easy to be a sucker to the high dividend story unless you recognise that almost all those stellar gains reported in the research reports do not account for tax!. In the real world, dividends are taxed as income which creates a massive drag on reported returns.
Historically, dividends have almost always been taxed less favourably than capital gains. According to research by Legg Mason Capital, in the US over the last 50 years dividends have been taxed on average at a rate of 50%. Meanwhile in the UK, dividends are taxed on a sliding scale according to your income band meaning that top-rate tax payers pay an awful lot more for dividend income than capital gains.
The other issue with income taxes is that they have to be paid immediately. Capital gains taxes can be…
