How to Avoid Being a Dividend Bag Holder

by | Aug 16, 2022


Dividends are back in style. For now. When growth stocks or crypto or anything else that has immediate upward momentum catches fire, most people will again forget about the value of dividends.

Do you like free money? Dividends are free money. Like….free! Yet many investors ignore them because they associate dividends with slow moving, boring stocks that don’t gain (or lose) value exponentially in short time frames. People crave instant gratification, and dividends represent the opposite of that impulse. Dividends are a good way to build wealth over time. Gradual wealth building as a concept gets favorable media commentary but requires a patience many people just don’t have.

Dividends are popular with a lot of investors, most of them older, retirement oriented types, so in general their benefits are not exactly a secret. But the proper way to understand which dividend assets to own (and not own) and the best way to use them is significantly more nuanced.

Many income investors who don‘t see themselves as greedy or impulsive still make some fundamental mistakes. You have to know what you’re buying, and simply chasing the thing with the biggest yield can leave you holding the proverbial bag.

A few practical rules of engagement to avoid being a dividend bag holder:

1-Don’t grab the thing with the highest yield without closely examining how the yield is derived. Some stocks, mutual funds or ETFs pay big yields but don’t consistently earn enough in their portfolios to continue the dividend. In many cases the dividend can be cut later on if the price of the underlying assets get crushed. These often debut with higher looking “sucker yields” in order to gather big asset flows.

2-Sometimes a smaller yield delivers better long term results. Owning high quality common stocks that pay 3 or 4% and holding them long term often gets you better results than reaching for yield with junky securities that often come crashing down later on. High quality stocks tend go up over time, junk usually goes down.

3-Avoid Master limited Partnerships. The MLP mafia will get me for this, but it must be said. These are destined to eventually go to near zero by design as the asset contained within them is depleted over time. The General Partner (not you) has all the voting power and gets an oversized management fee, you (the Limited Partner) gets a “cash flow” in the form of a dividend that may or may not be taxable, since it’s mostly your own money you’re getting back. You’ll also need to file an annoying K-1 form with the IRS, which will make your tax preparer hate you.  These sometimes do well when crude oil, natural gas or other underlying assets are rising, otherwise they generally do poorly over time. MLPs are also wrought with conflicts of interest. Take a look at the Wikipedia page on MLPs and you’ll see what I mean.

4-Manged Distribution Funds: These are usually in the form of closed end funds or ETFs and pay a rather high dividend yield that may be less (or more) than the fund actually earns in yield. This is not as bad as it sounds. The best of these usually own quality assets that earn most or all of the paid dividend over time, and these sometimes can gain value above and beyond the dividend in bullish market environments. The trick with these is to make sure you don’t overpay for them. Look at the price chart and realize these often trade in price ranges, so use sensible price targets to make buy decisions.

There is a lot more to discuss on this subject. I’ll be writing more on this in the near future, but for now, use common sense and understand that earning good investment returns from dividends is more a craft than a science. If it were a science, it would be easy. Following a few sensible rules can open the door to earning total returns that can far exceed nominal fixed income performance.

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