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Avoiding the Dividend Trap

“In a taxable account, dividends could have cost you anywhere from 0.3% to over 3.0% in returns PER YEAR since 1974. If your goal is optimizing your returns, then a blind allegiance to dividends could be a very, very bad idea.”- Meb Faber, Cambria Investments

A diversified portfolio is going to have stocks that pay dividends.  That’s virtually unavoidable and part of investing.  However, investors that focus on high dividend paying stocks within taxable accounts are leaving money on the table. 

We have no problem with owning dividend paying stocks in tax-deferred accounts i.e. IRA, 401k. In fact, this is the best way to shelter your dividend strategies from annual taxation.

The Double Taxation of Dividends

Some argue dividends are an inefficient method to return capital to shareholders due to “double taxation”.  Dividends are paid out of net income, meaning a company has already paid taxes on the proceeds.  The shareholder receives the divided and pays ~15-20% tax. 


$10 Revenue

$3 Taxes (30% Rate)

$7 Net Income – Paid out entirely as a dividend

Mr. Investor receives $7 dividend and is taxed 15%.

$7 Dividend

$1.05 Dividend Tax (15%)

$5.95 Net to Mr. Investor

Credit to Meb Faber who has been the loudest critic of dividends within taxable accounts (despite receiving flack for challenging the adored strategy).  He’s pioneered interesting research which can help investors maximize after-tax returns.  We summarize Meb’s findings (in bold) and share our observations (in italics).

The hunt for yield has caused dividend stocks to reach valuations levels never seen before relative to the overall market. Low bond yields have encouraged investors to seek dividend paying stocks to boost or sustain investment income.

Since dividend stocks are currently expensive, we prefer a shareholder yield approach combined with a value composite screen.  The term shareholder yield captures the three ways in which the management of a public company can distribute cash to shareholders: cash dividends, stock repurchases and debt reduction. Dividends are the most obvious form of distributing cash.  Source: Investopedia. 

Meb is advocating looking beyond dividends to find companies that return value to shareholders, but offer more attractive valuations than extended dividend payers.

Once you have a preferred value methodology, AVOIDING dividend stocks in the strategy could results in additional post tax excess return of approximately 0.3% to 4.5% for taxable investors. From 1974-2015, Meb finds that investing in an equal weighted value index and stripping out 25% of the top dividend paying companies resulted in consistent outperformance.

For the record, we believe in the merits of dividends i.e. income, dividend growth, owning stable companies, smoothing downside risk, etc.  There are greater investment tragedies than an investor owning dividend paying stocks in a taxable account.  However, by owning dividend focused strategies within tax-deferred accounts (IRA/401k) investors can avoid paying unnecessary taxes boosting after-tax returns.

Read more of Meb’s Research:

Dividend Stocks Are The Worst

What You Don't Want to Hear About Dividend Stocks

How Much Are Those Dividends Costing You?

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