A Common Income Strategy That Might Hurt Your Portfolio

Earlier this month, I shared a question we recently received from a long-time subscriber to The Daily Paycheck — our premium newsletter dedicated to picking the best high-yield opportunities on the market.

I also shared Chief Investment Strategist Amy Calistri’s response, along with my comments. Today, I’d like to follow that up with another Q&A. This one pertains to a common strategy investors who are seeking more income use, called “dividend capture.”
Q: I like quarterly dividends, but I don’t want to wait three months for the checks. Why couldn’t I move from the monthly dividends the day before a quarterly goes ex-dividend and then go back to a monthly for three more months and do it again? What kind of problems would I have other than price adjustments? — Larry N., Indianapolis, Indiana

Amy: Fabulous question Larry. The strategy you are describing is called “dividend capture.” Investors move their money from one dividend paying security to another — in an attempt to capture as many dividends as they can. Basically, they swoop in before the ex-dividend date. They hold the security for a couple of days to be sure they are on the dividend list on the record date. Then they move on to the next security before its ex-dividend date.

There are some challenges, however, if you use this strategy. Transaction costs are something to consider. While the discount brokers charge only about $5 a trade, you’d have to buy a quarterly payer four times a year to collect its dividends. You’d also have to sell it four times a year to get back into your monthly payer. The same number of transactions would be required for your monthly payer. While $160 may not seem like a lot, it might be a significant percentage of the dividends you’re trying to capture, depending on the size of your total investment.

You mentioned price adjustment. That’s perhaps the most difficult hurdle to clear. The price of a stock generally drops by roughly the amount of its dividend once it trades ex-dividend. After all, the stock is less valuable to new investors once they can no longer qualify for the pending distribution. Over time, this trend reverses. The stock’s price will slowly begin to rise throughout the quarter as it approaches its next dividend date. It becomes more valuable again because investors can receive the newest dividend.

But when you’re practicing dividend capture, you don’t have time to wait for a full price adjustment. So you may have to settle for a short-term capital loss to capture the dividend.

There is another factor to consider. If you are practicing dividend capture with stocks in a regular taxable brokerage account, you will likely be paying higher taxes on your dividends. To qualify for the reduced dividend tax rate (15% for most taxpayers), you must hold a stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. So if you were to buy a stock just before its ex-dividend date, you would need to own it for roughly two more months to qualify for the reduced tax rate.

In theory, dividend capture is a great way to get more dividends for your investment dollar. In practice, however, its costs can offset much of the benefit.

Brad comment: Dividend capture strategies have long been discussed among investors as a way of enhancing income. But as Amy mentions above, there are some risks. Instead, most investors seeking more income are better off sticking to a dividend reinvestment strategy like the one Amy uses.

Take a look at the chart to the right.

If you invest $20,000 in securities paying a 7% yield and reinvest dividends, then your portfolio would be worth $39,343 after 10 years.

If your holdings boost their payouts by just 5% annually — which is reasonable (giant blue chip AT&T has been able to beat this) — your portfolio would be worth $46,475. That’s an increase of 132.4%.

This assumes zero capital gains.

Not bad.

But thanks to the power of reinvested dividends and dividend growth, after 10 years your portfolio could be generating $5,299 in annual income — that’s 278.5% more than if you hadn’t reinvested. You’ll also be generating an effective yield of 26.5%.

The numbers don’t lie. All it takes is a little time on your investment horizon, more money to initially invest, or additional dollars to invest each year — ideally, a combination of all three. Then the numbers only get better and better.

As I mentioned recently, Amy just released a devastating report to readers of The Daily Paycheck on the latest blow to retirees. Starting this month, retirement benefits for as many as 270,000 Americans could be slashed by as much as 50%. You can see the details of our findings in this presentation.

With all this in mind, I can’t stress enough how important it is for income investors to use the power of compounding and dividend reinvestment to their advantage. It doesn’t matter if you have two years or 20 — it’s time to get started today.

Luckily, if you check out Amy’s latest report, you’ll also learn about three safeguard measures we recommend you can take right now to protect your retirement. They’re safe, easy and can make all the difference when it comes to facing the challenges investors are up against. Again, you can access Amy’s report right here.