How to Use Dividend Stocks in a Hedged Portfolio

Dividend Stocks

While we recently ran an article explaining why dividends never make sense, a lot of stocks offer them. We don’t want to just shun them, but they need to earn their keep.

If we are attracted to the idea of investing in higher dividend stocks, as many people either were already or have become more attracted to them due to the low yields on bonds these days, we need to make sure that we understand the deal here with dividends. If not, we can’t possibly make the right decisions.

Barron’s has this topic as their feature article over the weekend, and provides a lengthy discussion explaining the virtues of dividend investing and even providing a few cautionary notes. The article could do a better job at explaining things though, which is where we come in.

Dividends are a relic of bygone days, and aren’t anything that serve any valid purpose today, other than to limit the growth of a company and a company’s stock, while subjecting their shareholders to a greater tax liability than if dividends did not exist.

There is a big outcry against one of the things that Democratic presidential candidate Elizabeth Warren is hoping to implement, which is seeking to have investors pay tax on gains while they are still in stocks. There are two big concerns here, which are people paying more tax and all that money being taken out of the market and out of individual stocks, which surely would have a bearish impact and a pretty significant one.

Dividends serve to do the exact same thing though, although hardly anyone complains about this or even thinks about this at all. Stocks pay dividends, you just got a payment, sure you will have to give some of that back to the tax man, but that’s just the way it is.

Dividends also take money out of the market, a couple of percent on average, the same way a tax would, and this does serve to limit market growth to be sure, even though some of this becomes reinvested. If you own a company that regularly spills money like this, this does impact your overall return, and this is why some growth companies just say no to paying dividends, because they want to grow more and make more money for their shareholders in the end.

Most stocks do pay them, and all things being equal, this should have us saying no to investing in dividend stocks ourselves. Some pretty good ones like Apple do pay them though, and things are never really equal, so this issue serves as one among several considerations when choosing a stock or remaining in one.

One of the lessons that most investors need to learn though is that looking to buy a stock and looking to hold a stock should never involve different criteria. If you would not buy it, you should not hold it either, especially when you could put your money into something better that you would buy.

If you happen to be in stocks that pay dividends, you need to compare the overall benefits of this stock, including the drawbacks from their dividends, with other stocks to decide which would be best to hold. This matters just as much if you are looking to invest or are already invested, especially given that this decision to buy may have been made some time ago and things change.

The next thing to realize, and it’s even hard to believe that this even needs to be mentioned but it does, is that at the end of the day, it is how much money that you have made or lost with a position that matters, and it’s the only thing that matters. Even though it might seem hard to believe, this is the point where dividend seekers go off the rails, assigning a much greater weight to money made through dividends than made by price appreciation. If anything, the reverse is true, due to the additional tax liability involved with dividends.

All Dollars Earned Are Worth a Dollar Regardless of How We Made Them

When you sell a profitable position, some of your profit will come from capital gains, from the price of your stock appreciating, and some may come by way of dividends, but it all converts into dollars, and one dollar spends the same way as the next. If we don’t understand this one simple point, we will end up lost.

Barron’s points out that there are two main strategies to dividend investing, and they at least have total return as one of them, although it is the only one that makes sense. The other strategy has us focusing on income, although you simply cannot do that with a common stock even though you may hedge these positions with a healthy amount of bonds.

You can hedge your risk here, let’s say by 50%, with the other half in bonds, but that does not turn these stocks into income investments, as total return is still fully in play even though it may be watered down by half. There are some things that you can do to make your stock positions more like income though, but hedging with bonds won’t do it.

We have to always look to total return with any investment, and this is true of any common stock. People get wildly confused about this with bonds as well, and while bonds can be set up as a pure income investment if held to maturity, most of the time we don’t and this turns bonds into a hybrid investment like stocks are, where we need to pay attention to overall return. A lot of people don’t though, looking at only one side of the coin while the other side is very much in play but tends to be ignored.

Bonds don’t move all that much, at least normally, even though they sure have over the last year. Stocks move a lot more, and therefore the income component of the investment, the dividend, plays a lesser role with bonds, meaning that it comprises a smaller percentage of total return.

If we are thinking that we can just buy stocks that pay good dividends, on that basis, and not be stumbling around blind, we are woefully mistaken. It’s not that easy to imagine how anyone would manage to reconcile such a thing with themselves, but in a lot of cases we’re conditioned not to think at all, and this is a very good example actually.

A lot of older people are turned on by this approach, and particularly relish the dividends that they earn in their retirement years, where they are looking for income. If you are wanting to use the money now, you have to declare it as income now anyway, as opposed to collecting these in years where you wish to accumulate your investments.

If you choose well, this can set up as something not so bad, and if you never plan on selling your stocks and can just live off the dividends, you aren’t going to worry about things like bear markets or your being in stocks that are getting hit.

This still isn’t a good approach though, as it requires that we embrace unlimited risk, both to the market value of our stocks and our dividends as well, which may be reduced or eliminated in leaner times.

Some Dividend Stocks May Make Sense, But Only the Ones That Actually Do

The only sensible way to manage dividend stocks, which refer to stocks that pay higher dividends, is to ensure that all stocks carry their weight, meaning that they add value to our portfolio and value that cannot be readily surpassed with a different strategy.

What people like about dividends is that they at least appear closer to hand and easier to predict as well. They just look at what a company is paying these days and assume it will continue., and then just calculate their yield. What you end up with, every time, is both the dividends and the capital accumulation and we need to take both into account to get an idea of what both the potential risks and returns may be.

The fact that so many people are willing to reduce or even eliminate their due diligence by being tempted by a dividend that is only part of the story is actually a scary idea. The dividend may be nice but the other side of the coin may be pretty much anything, including some ugly faces. We always need to look at both sides of the coin here, but the dividend side is so pretty that we often do not even peek at what is on the other side, or realize we even should.

Barron’s mentions what they feel is a greater need for income from investments today due to how few people receive a pension. When it comes to stocks though, it’s all income, whether it accumulates through dividends or capital growth. If we wish to tap into our savings, we can just redeem an appropriate amount of stock, and therefore dividends are not required at all to earn income from stocks.

While we need to always consider total return, this does not mean that maximizing total return should be the goal. Those who tend to be attracted by dividends tend to be older, and more in need of hedging. If you don’t have all that much time left, you can’t surf the waves like longer-term investors can, and you may get dropped on your behind on the beach if you are not careful, without time to ride out further waves as needed.

Aside from considering these higher dividend stocks alongside other stocks to see how they measure up with regard to total return, which they generally do not fare all that well, some high dividend stocks are of a sort that can be useful as a means to hedge risk.

Some high dividend stocks provide excellent hedges, and this is more than not dropping a little less than the average stock in a bear market, as these hedges can even retain their value during some of them, and lose far less with the worst of them.

You do pay a price in total return, but this can be a price well worth paying, because it’s always about seeking returns while keeping risk manageable. If there is a greater need to manage risk, we must put more weight on this.

There are better ways to hedge, but they require some real skills at timing investments, and the great majority of investors aren’t really interested in this, as they want to keep things simple. We should at least define our risk by some measure and not just stubbornly sink into some deep quicksand pits, thinking that we are trapped in the sand when all we really have to do is step out, but unless we are actively managing things, we need some other way to manage the less than big stuff.

We do need to make sure that the ones that we pick genuinely function as a hedge, and we both do not want to pay too high a price in lower returns and pay too much in bad times, when we needed to be protected more.

Utility stocks generally serve as a good hedge against the market, although we very much need to be selective here as some are superior to others. PG&E is a clear example of what can happen if we neglect this.

High dividend stocks therefore do have their place, and may have a significant role to play with those who require tighter risk management than the just throw your seeds into the wind approach that is widely used. It is all about finding the right balance, and we can dial down risk quite a bit if needed, including adding treasuries as required.

We need to better understand why dividends aren’t all that they are cracked up to be, what sort of risks that are involved in investing in any common stock, the fact that investment income can be accessed without earning dividends or interest, and also end the idea of placing undue weight on them and even focus so much that the big picture becomes blurred.

Then and only then can we prepare ourselves to plan and execute a more sensible approach to managing our risk while still seeking returns that are suitable to our tolerances.

Eric Baker

Editor, MarketReview.com

Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.

Contact Eric: eric@marketreview.com

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