Wednesday, October 17, 2012

How to avoid being a dividend loser

Dividend losers focus on excuses that prevent them from achieving their goals of financial freedom. Dividend Winners on the other hand, focus on creating specific goals, and the steps to make them a reality.

The first excuse that dividend losers use relates to the fact that since dividends get taxed at 15% per year, this somehow makes dividend stocks an inferior investment. Dividend losers use companies like Berkshire Hathaway (BRK.B) to prove their point. They do like that fact that it has managed to reinvest dividends from its various subsidiaries into more businesses. They hate to have to research a company, formulate a strategy and execute that strategy however. Reinvesting the dividends from their income portfolio seems like too much work for dividend losers. This makes dividend investing a losing proposition to dividend losers. Unfortunately, there is only one Berkshire Hathaway, while there are over 100 dividend champions – companies which have raised dividends for more than 25 years in a row. While dividend losers are looking for the next Berkshire Hathaway, dividend winners are creating their own Berkshire Hathaway’s with the generous dividends from their portfolios.

Besides the reason behind taxation of dividends, another reason why investors fail to make good investing decisions is because certain pass-through entities generate slightly more complicated tax returns. A prime example of that includes pipeline Master Limited Partnerships such as Kinder Morgan (KMP) as well as Enterprise Product Partners (EPD). Investors should focus on identifying the best opportunities that would deliver the best results first, and only worry about taxes later on. I have witnessed investors who wanted to sell stocks, but did not, because they waited a little longer in order to qualify for a long-term capital gains treatment. After they qualified, the paper gains had evaporated and turned into losses. Warren Buffett for example made his first $20 million by running a hedge fund which was structured similarly to a master limited partnership of today. Investors who avoided his partnership because they did not want to complicate tax returns missed the opportunity of their lifetimes.

Another excuse that dividend losers utilize is that they do not have enough money to start investing. Investors who fail to save a sufficient nest egg, would not be able to retire. Buying high yielding stocks such as American Capital Agency (AGNC) or Hatteras Financial (HTS) is not going to solve that problem. When the spread between short-term interest rates and the rates on mortgage bonds declines, investors would see dividend cuts across the board, which would likely lead to them searching for a job in order to pay for their expenses.

To summarize, in order to avoid being dividend losers, and live off their nest eggs, investors should be able to focus on the best opportunities in the markets first, and worry about other items like taxes later. By being flexible, and adapting your strategy to fit the external environment, and not simply searching internally for strategic insight, would help in avoiding pricey mistakes that could derail one's retirement.

Full disclosure: Long KMR, KMI and EPD

Relevant Artciles:

How to be a Dividend Winner
Dividend Champions - The Best List for Dividend Investors
Build your own Berkshire with dividend paying stocks
Master Limited Partnerships (MLPs) – an island of opportunity for dividend investors

1 comment:

  1. Thanks for another awesome article reminding us of common investing pitfalls and to avoid too much risk. I would like to add that you can avoid the tax issues by applying dividend growth strategy to a (Roth) IRA and/or children's ESAs, for example. Also, kids can have up to $750 (I think) passive income p.a. without having to pay taxes on it. So there are a few ways to avoid the tax issue. Personally, I don't mind paying the taxes as much as the hassle with filing the returns. But you can avoid it that way.

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