I see a lot of people devising strategies around dividends while on the other side of the spectrum some people prefer growth and go out of their way to avoid stocks and funds that pay out high dividends. The allure of dividends (I think) is that you can see cash go into your account – but there are three reasons I don’t like them:
- On a philosophical level, it bothers me when a company doesn’t believe it can generate a better growth than you can as a private investor and thus prefers you have the money.
- On a practical level, dividends force tax events on you. If you have pure growth you can select exactly when to sell stock, realize gains and pay taxes.
- On a smaller note, there will usually be a cost involved with reinvesting the dividends. Even without brokerage fees there is still a gap between buying and selling costs.
In this small post, I will just do a quick review of the effect of being forced into these tax events. I know some proponents of dividends will argue that dividend stocks do better over time. I’m not qualified to argue neither for or against that – if I was I wouldn’t be utilizing index funds and trying to capture overall market performance. People who do believe they have the tools to do detailed stock analysis, draw conclusions on future growth from past performance and generally outperform the market significantly: feel free to ignore this post and go earn some seriously big money instead 😉
dividends and taxes
Outside of retirement accounts any dividends you are paid will be taxed as stock gains (i.e. 27% on the first 51,700 – 42% on anything above). Mathematically speaking, paying tax on dividends will in the very, very long wrong always be inferior to only paying taxes when selling. For an exponential function f(n)=a*(1+r)^n this is because a higher growth (r) will always win out against a higher base/lower tax (a) given the time (n) trending toward infinity. Although we’re in this for the long game we still need to think in practical timeframes though 😉
If we have a stock/index fund growing at 7% that pays out dividends of 5% of stock value then the actual growth would be (7%-5%)+(1-27%)*5%=5,65% if the 5% falls within the progression limit for 27% tax. This is obviously lower than 7% but at the same time this disadvantage is partially negated by the fact that the cost basis of the investment is raised and that the taxed portion of the growth will not be taxed again later. In effect, you just prepaid taxes. So, in the spreadsheet further down we will look at the actual cost of those prepaid taxes over a realistic time frame.
One thing to keep in mind is that if you systematically pay tax on dividends at 27% you might raise your cost basis enough that you avoid a 42% stock tax in the future that you’d otherwise incur. This is independent of dividends though since you can do the same (if you so choose) by selling a portion of your stocks at a given time and repurchasing a similar stock/fund. For now, I will abstain from considering that and focus on dividends but I will make sure to write a bit about tax-harvesting soon.
Dividends and costs
While prepaid taxes are the major issue with dividends there are also some costs involved that we can’t just disregard. If you are still in the accumulation phase, then any dividends paid out to you will need to be reinvested. This reinvestment comes with costs – specifically brokerage fees and buy/sell-spread or purchase fees (“emissionstillæg”). The brokerage fees can be avoided in some instances either by using a fee-less option such as Nordnet’s “månedsopsparing” or by including the cash in your next scheduled transaction. But let’s look quickly at the other price you might pay, however small.
Whenever you buy stocks or funds there is a spread between the sales price offered in the market and the purchase price offered. If you choose to click buy you pay a bit more than what you could sell the share for – this is known as spread. In efficient markets with a lot of trades this spread will be relatively low while it might be big if you are into small, low volume stocks. In the case of funds the fund itself has an option to issue new shares or buy back shares. This is relevant in cases where the prices offered in the market differ substantially from the internal value of the stocks held in the fund as it limits the max spread you will see. For the fund, not to lose money for other investors when they issue such new shares or buy them back there are fees called “emissionstillæg” and “indløsningsfradrag” for respectively buying and selling from/to the fund. For Sparinvest (a popular Danish provider of index funds) those fees are typically just below 0.30% for their index funds and this is thus the max you should pay relatively to the value of your purchase. Most often it will trade at only half that premium though so generally the fees here are small for long term investors but they still do add a bit off annoyance to receiving dividends since you must pay those small fees every time.
On the other hand – if you are in the consumption phase then dividends may save you a bit in fees by avoiding sales fees and brokerage fees. Since exponential growth benefits you more in earlier years those fees won’t mean as much but at least it’s nice to be able to list a pro 🙂
So, let’s have it!
It’s nothing fancy but I made a small spreadsheet to check the effects of dividends on growth. The scenario is weighted a bit against dividends since I didn’t reflect 42% progressive stock tax that you might avoid but as I said you can always emulate that, so the sheet just shows the max you might lose by having high dividend payouts. The sheet is over at: Calculator: Dividend scenarios.
As you can see a 2% dividend vs. a 5% dividend under the shown assumptions will earn you 32,000 kr extra on a 100,000 kr investment over 30 years of moderate growth. A 0% dividend (growth stocks) vs. a 6% one will over 40 years lose you 154,000 kr on a 100,000 kr investment.
In essence you should avoid stocks and funds that pay a high dividend outside of your retirement accounts – if you can. In retirement accounts, all growth is taxed so the distinction between dividends and growth is negligible. The problem for us Danish investors is that Danish (index) funds are regulated in a way that they cannot abstain from paying dividends. When the funds have capital gains either through realized growth or through dividends on the underlying stocks they are required to pay it out to the shareholders (Read here). It’d be much better for most of us if they could just invest those gains back into the index but that duty falls on us with the associated costs. While it is not the end of the world it certainly makes those index funds less attractive and the consensus on buying SparInvest index funds might need review. Of course, a slightly lower growth is still better than losing all your money to lack of diversification but that is the usual game of risk/reward.
What are your thoughts? What do you buy in your taxable brokerage account? I’ve yet to begin my journey in taxable brokerage territory so I still have some time to make my decision but the idea of buying and holding single growth stocks still lies at the back of my head. Screw diversification – I have that in my retirement accounts 😉