Why are investors always inundated with lists of stocks going ex-dividend in the coming weeks or months?
Experienced investors know that there isn’t any money to be made by investing in such stocks solely for the dividend payout, but this might be lost on newer investors who get sucked into the trap of what appears to be easy money.
Consider the following a permanent footnote that should accompany the publication of any such list:
Buying a Dividend Doesn’t Capture Any Excess Returns
Even though everyone likes receiving a dividend payout, there’s a right way and a wrong way to go about it:
- The right way: Buying stocks that are fundamentally sound and undervalued, and that have attractive yields with the potential to increase in the future.
- The wrong way: Trying to goose returns by buying stocks that are about to pay a dividend.
The simple reason this doesn’t work is that payments are anticipated well before the payout and are therefore factored into stock prices. The amount of the dividend is thus accompanied by a drop of the same dollar amount in its share price. If a $20 stock pays out a 25-cent dividend, its price will fall to about $19.75 on the ex-dividend date (the first date at which new investors are no longer eligible to receive the dividend). The investor therefore doesn’t actually earn any money — he or she merely receives a return of capital.
This can sometimes be hard to discern, since the stock price continues to move on the day the stock goes ex-dividend. For instance, Microsoft (MSFT) made its last dividend payment on May 14. The payout was 23 cents, and the share price adjusted from $33.03 to $32.80 to account for the payout. However, at the same time, the stock rallied and closed the day at $33.53 — more than making up for the drop associated with the dividend.
This sort of price action only serves to add to the confusion surrounding the ex-dividend process.
Taxes Make Ex-Div Trades a Losing Proposition
If it weren’t for taxation, buying stocks on the verge of going ex-dividend wouldn’t create any pain for investors; it would simply be a wash. Unfortunately, taxes do play a part — which is why attempting to capture dividends is an unwise strategy.
Say an investor puts $10,000 into a stock with a 5% yield that’s about to go ex-dividend. The investor receives the $500 dividend, but that payout is taxable as regular income. If he or she is in the 28% bracket, the after-tax dividend drops to $360. Assuming all else equal with the share price, the investor walks away from the trade not with $10,500, or even $10,000, but instead $9,860. This can count as a capital loss, but 1) it needs to be recognized and offset by a capital gain, and 2) current capital gains rates don’t make up for the tax bite on regular income.
The Bottom Line
In a perfect world, this explanation wouldn’t be necessary. Investors would recognize that there are no free lunches, and that if buying stocks before the ex-div date actually worked, people would be able to use that strategy every day, ad infinitum, and we would all be multi-millionaires. However, the persistent appearance of ex-div lists might lure the unwary into pursuing a strategy that will leave them with an unwanted tax bill at year-end.
The best bet? Give the lists a quick glance for informational purposes, but don’t make any trades solely on the basis of an ex-div date.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.