Your Dividend Investing Questions Answered

I recently asked for a list of questions my readers had on dividend investing. Thank you for all who replied. Here are my responses to 12 questions that I received.

1. What are Important Dates for Dividend in Investors?

There are 4 important dates that all dividend investors need to know.

1. Dividend Declaration Date: This is the date that the Board of Directors announces and approves the next dividend amount.  This is the first time where the market knows if the dividend will change from the previous amount.  During this announcement they will also list all the other relevant dates.  The payment of a dividend is determined by the Board of Directors, they can alter it whenever the business needs to.
2. Ex-Dividend Date: This is the date where it is too late to buy the stock in order to receive the next dividend payment.  “Ex” stands for exclude, so you are excluded from the right to the payment.  Whoever owns the stock on the day before the Ex-Dividend date gets the dividend.
3. Record Date: this date is less important, but this is the date that the company officially documents who is the rightful owner of the stock that is eligible for the dividend.  This date is more of a technical date since the settling of stock trades usually takes a few days.  As long as you own before the Ex-dividend date you will get it
4. Payable Date: this is a fun day!  This is when we get paid.

2. How are distributions (capital gains and dividends) from retirement accounts taxed?

This one was quite surprising to me when I first started investing.  All distributions, whether it is withdrawing the principal or withdrawing dividends, are taxed at your regular tax rate from a retirement plan like a Traditional IRA or 401(k).  The dividends and capital gains are tax-deferred while you are working but when you take them out they are taxed as regular income.  The long term capital gains and qualified dividend tax rates do not apply. Money in a Roth IRA will not be taxed as long as all the requirements have been met.

3. Why do some funds (mutual & ETF) distribute extra at the end of year that might increase your tax and even move you to the next bracket.

The managers of mutual funds and ETFs buy and sell securities during the year to meet the needs of the fund and hit their objectives.  In doing this there may be capital gains that occur.  Those capital gains are usually passed on to the shareholders, usually at the end of the year.  This payment would be in addition to any dividends paid.  This extra payment can sometimes be a few dollars per share.  That amount of income will be taxable to the shareholder if held in a brokerage account.  The potential problem is that you may not be aware and will get a large tax bill. Also, the tax bill will be sent to whomever owns the shares at the time of payment, so even if you didn’t own the shares the whole year you will be the one that is responsible for the taxes.  The buy and sell decisions are completely up to the fund manager and as an owner we don’t have any control.  Vanguard recently made some changes to some of their funds which caused some big institutional investors to sell their shares of one fund and buy another.  This mass selling caused capital gains, and that was spread out among all shareholders, even if you didn’t sell.

4. Can you explain why some companies like DVN are adopting a variable dividend policy: Core + something extra, if possible?

This is a great question.  A lot of European companies handle their dividend policy like this.  It is also common for energy companies and other cyclical businesses.  Their business model cycles have peaks and toughs so it might make sense to adjust the dividend as the income allows.  Think about it, dividends are payment to the owners, if the business does well, the owners get paid more, if the business is struggling temporarily, it makes sense to hold back some earnings in the company to make it through the downturn.  If you have a set dividend policy then you might be paying out more in dividends than the company is bringing in in revenue.  If you owned your own business and times got tough, you would probably reduce your salary to compensate during the rough times and then raise it again when things are going well.  It is the same for these companies with their variable dividend. 

5. Explain the power of compounding small dividend increases over time (reinvesting dividends in more shares).

It is said (and may be folklore) that Albert Einstein said that compounding is the 8th wonder of the world.  While he may have not said it, it is really true.  The first years of dividend compounding might not seem like a lot, but over time those little increases and reinvesting the dividend will compound and eventually the compounding graph will look like a hockey stick.  Slow and flat at the beginning and then has a sharp turn up.  Give it time and keep reinvesting and your income will do the same.

For instance, a $1,000 one-time investment, 3.5% yield, growing at 8%:  Year 1 – $35 in dividends, Year 5 – $55, Year 10 – $98, Year 15 – $174, Year 20, $308, Year 25 – $549.  You can see the exponential growth in the later years, and this is from just a one time investment and reinvesting the dividends.

6. Why do growth investors not understand the simple power of knowing that all your bills are paid from dividends + a little more = freedom from the grind?

There are many ways to make money in the market, you have to find the one that works best for your personality and risk tolerance.  For me, that is dividend growth investing.  With Growth Investing, you are investing with the expectation that the value of your holdings goes up over time and when you need to use the money that you can sell the shares at a higher price than you paid.  The limitations of this investing method is you have to believe that the shares will in fact be worth more when you need them.  There have been plenty of times throughout history that growth stocks have not grown.  Look at the lost decade of 2000-2010.  If you were building up your investments and hoped to sell them to live off of, you may have to sell at a loss to get the income.

With dividend growth investing, you don’t have to rely on capital appreciation to live off of. As long as your holdings continue to pay their dividend, you can use that money and never sell a single share of stock. This allows you freedom to not worry as much about the ups and downs of the market and timing when to sell.

7. Explain how simple a covered call and put are. And indeed provide for a pseudo dividend. And actually reduces the risk of the stock loss versus an outright purchase of shares.

I love covered calls and cash secured puts.  They are like rocket fuel for dividend investors.  With covered calls, you are selling someone the right but not the obligation to buy your shares from you at a set price by a set date.  As the seller you have total control of the terms of the contract.  For selling that right, you get paid cash upfront that you can use to buy more dividend stocks or use the cash however you would like.  For Cash Secured Puts, you are selling someone the right to sell you their shares at a price and timeframe that you agree to.  For selling that right, you are paid cash upfront.  If the stock trades under the contract price you set, you have to buy the shares at that price, even if the market price is lower.  Each has risks and rewards, but it can provide additional income that you can use to grow your accounts. I have discussed covered calls here: https://dividendstockpile.com/how-to-sell-covered-calls-on-dividend-stocks/

8. You have a large selection of dividend stocks. Maybe something about why so many versus a few. Is it diversity or future growth potential? I personally couldn’t keep up with your list. Maybe the simple question is “how many companies is enough to achieve your goals? “

I like to have diversity in my holdings.  This provides a more stable dividend income than having just a few holdings.  I limit my positions to be no more than 5% of my portfolio but many of my holdings are much smaller, like 1-2%.  Think of it this way, if I only have 10 positions paying dividends and one cuts the dividend, I am out 10% of my income.  If I have 20, I am only out 5%, if I have 100 holdings, then I am only down 1% of my income.  It is really a risk management strategy more than anything else.  

The second part is that I have been investing for a long time so I have holdings that I have bought years ago.  I may not be adding to them any more but they are still solid companies that have grown nicely over time and my yield on cost is very high, so I don’t want to sell them to make room for another holding.  I would rather just keep them and let the compounding happen over time.  Everyone that says you keep a lean portfolio states that you can’t possibly keep track of all of them, and while that may be partially true, investing is not an everyday activity.  Once you research the company the first time, all that is needed is an occasional look and review of the financials to make sure they are still on track.  We should not be looking to change our investments every month or every quarter.  You should only make a change if the business is broken and their prospects are permanently altered.

If I was a growth-only investor, having a concentrated portfolio on only my top convictions will probably provide higher returns but I am not in it for growth, I am in it to live off the dividend stream in the future,  that is what is most important to protect.

The conventional advice is to have 18-30 stocks in a variety of industries, this will reduce the risk of being too concentrated, but there is no set rule and you have to do what makes sense for your investing style and risk tolerance. 

9. I would like to know exactly how to reverse engineer my investing goals to achieve a certain result.

All investing is personal so your goals will be different from mine and different from the next person.  While we might all be dividend investors, our end goal could be very different.  Some people plan on using the dividend income right away, others it could be 30 years from now.  Others might want immediate income and are not worried about growth, others might want to look at a total return point of view.  Either way, as long as you have a plan and stick with what works and makes sense for you, go for it.

With that said, in order to reverse engineer your goals, let’s take an example that an investor has $10,000 invested today and wants to be able to use the dividend income 20 years from now and needs $50,000 a year in income at that point.  How much do they need to invest each month to get there?  We have to make a lot of assumptions but hopefully this will provide a template.  Let’s say you have a portfolio yield of 3.5% and the dividend grows at 8% a year (very realistic in today’s market), how much will you have to invest each month?  Given these parameters, investing $1500 a month would get you $51,318 a year in dividends at year 20.  You can adjust to meet your needs but this is a quick back of the napkin approach to reverse engineer your goals.

10. What’s the strategy you use? I have some stocks on red and some on green – I want to buy more on Monday – so I’ve been thinking it’d be better I put the money on the red ones, as it’s “cheaper” than I’ve paid. Is this correct? Should I think about something else? It seems they’re on red just bc of the market, nothing special has happened to it..

My investment plan has been established in advance so any time I have extra cash there are only two things I have to think about.  The first part of the plan is to set an allocation limit to each investment based on my conviction of the company and my risk tolerance. I have done detailed research on all my holdings so I set my limits based on my research.  I set limits of no more than 5% of my portfolio in any one holding, and that 5% is only for my top convictions.  Most of my holdings are at an 1-3% allocation.  These limits make sure that I am properly diversified and stops me from adding to holdings out of emotion.  The second part of the plan when it comes to allocation is based on which holdings that are underallocated are the best values.  Say I have $1,000 to invest, I will look at each of my holdings that are not at the allocation limit and decide which ones are the best value, not necessarily which ones are the lowest from my cost basis.

11. What do you think about index funds like VOO or others like, will that be a good idea and it can be bought in fidelity or others platform or just Vanguard?

Broad market ETFs like VOO and SPY are good core positions for most portfolios.  These ETFs follow the broad indexes and give you a piece of a large number of companies.  It is instant diversification and you will do as well as the market index it tracks.  I have small allocations to VOO and QQQ but since they are not specifically focused on dividends I have not added to those positions in years.  You can focus on dividends and have broad exposure using a dividend ETF like SCHD or VYM.  These ETFs have between 100-400 of the best dividend stocks and will give you plenty of diversification.  The only downside of these two funds is that they don’t have large exposure to names like Apple or Microsoft so you may want to add a technology focused fund if you want exposure to that sector. 

You can buy VOO and most other ETFs on any brokerage platform, there should not be any limitations (US investors at least)

12. What markers/values (P/E ratio, for example) do you look for when evaluating & researching a new stock to invest in?

While there are hundreds of metrics you could use, and some are specific to certain industries, you have to review both the quantitative as well as the qualitative aspects of a business.  Valuation metrics (P/E, P/S, etc) are important to know if the company is trading at a good value, you will also want to look at revenue growth, debt coverage and debt outstanding, if they are issuing more shares unnecessarily, payout ratio for the dividend, are the revenues and net income growing at a similar rate or better.  The qualitative side is do they have good corporate governance, do they exhibit openness with their communications, are there competitors, are they shareholder friendly, etc.  Also you will want to look at your own personal values – do they operate in an industry that you want to avoid (tobacco, prisons, etc), do they pollute the environment, do they have any management scandals, or get their supplies from questionable sources, etc.

I would say it is more of an art than a science, you have to look at the company holistically and develop an understanding and comfort level with the company.  Ongoing review of the company fundamentals should also be done so that you continue to understand the company and if anything has substantially changed since when you first bought them.

Thank you to everyone who submitted questions, if you have any additional questions please let me know in the comments!