This post is dedicated to those investors who’re obsessed with capital gains.* I’ll admit, I was once one of those folks. In fact, back when I traded stocks, selling at a loss was always a fail. Now, I’m no longer concerned with losses and focus on long-term dividend investing. In other words, my investments are strictly buy and hold with minimal trading.
Let’s take a step back and explore the concept of dividend investing. I like to think of it as buying income producing vehicles. In this sense, the dividends are your “income,” and the underlying stock or index fund is your “principal.” Put another way, I treat stock or ETF investing as if I were loaning money to a corporation and taking interest payments in the form of dividends.
Why is this preferable to stock trading for capital gains?
1. Dividend Investing Can Sustain Early Retirement
If you’re a stock trader that’s only concerned with capital gains, you may encounter trouble after the paychecks stop coming. By trading off a lump sum without additional funds to dollar cost average, it becomes harder to maintain a steady rate of return that can fund the rest of your life. For example, you’ll need a 5% annual return off $1,000,000 just to receive $50,000 a year. The 5% return isn’t the hard part though, it’s generating that 5% a year every year for the rest of your life. And that’s a lot of years if you retire early.
Dividend investing on the other hand is much simpler. Since many companies won’t pay dividends unless they’re consistently making profits, dividend payouts tend to stay consistent year after year. So if you put your $1,000,000 into a stock that has a 5% dividend yield, you’ll most likely receive $50,000 a year for the next few years.
2. Dividend Investing Saves Taxes
Remember that 5% that you have to make every year from capital gains? Well, you’ll be taxed every time you realize those gains from a sale. And if you sell within a year of your purchase, you’ll be taxed at the short-term capital gains rate. That means that all your gains will be taxed as ordinary income. On the other hand, if you sell after one year, you’ll be taxed at a much lower long-term capital gains rate.** While this may sound good, holding a stock for longer than a year is not realistic when you’re relying on capital gains to fund your retirement.
Nonetheless, you can take advantage of an almost identically low tax rate for dividends by holding a stock or index fund for just 60 days.*** These dividends become “qualified” dividends and will not be taxed as ordinary income.
3. Dividend Investing Saves Time
Last but not least, dividend investing is passive and automated. All you need to do is buy and hold. Stock trading on the other hand can be as intense as a 9 to 5 job where you’re constantly watching the market for buy or sell signals.
So there you have it, a slightly biased opinion on why dividend investing trumps capital gains investing. Which do you prefer?
*Capital gains are profits from the sale of investments. For example, if you buy a share of stock at $5 and sell it for $10, you make a $5 capital gain.
** For those in the 25 to 35% tax brackets, the long term capital gains tax is just 15%.
***You must hold the stock for at least 60 days during the 121 day period that begins 60 days before the ex-dividend date (the first date after the declaration of a dividend on which a stock purchaser is not entitled to receive the next dividend payment).