🦷 Why you don't need dividends for monthly cash flow -.
Dividends put to the test 🦷
Hi guys, this post is to explain why a dividend-only investment strategy is not a panacea and as the young whippersnapper that you are, you should definitely reconsider whether you should really focus fully on dividends and payouts with an investment horizon of more than 15 years.
Stop! What?
Dividends always make sense! After all, I regularly get money flushed into my account without doing anything for it. Anyway, I prefer to have the money directly in my hand, so that no one can take it away from me. And anyway, dividends are a sign of quality; if the company has paid out dividends for the last 20 years, it will do so for the next 20 years as well.
Oh, and I want to live off my monthly cash flow in my old age, then the portfolio can continue to grow in peace and I can live off the dividends! It's much better than constantly withdrawing something from the portfolio, because at some point I'll have nothing left. That can't happen to me with dividends!
Well? Who would sign one or the other sentence above in the same way?
What if I tell you that all of the above is a misconception, based on assumptions and a dividend strategy can have its pitfalls. What you should keep in mind when implementing your dividend strategy, we clarify in this article.
If you want to do further research after this article, you can simply google the terms "Dividend Fallacy" or "Homemade Dividend Policy" and/or read the article by Gerd Kommer listed in source [3].
Introduction - Why are dividends so popular?
In times of zero interest rates, when we hardly got any interest on our savings, dividends were proclaimed to replace interest. In 2008, the last time there was almost an average of almost 2% on the overnight money [1]. There is certainly no question of savers being spoiled in the last decade. So alternatives were needed.
If savings no longer yield anything, investments have to be made. In the past decades, the capital market has regularly generated higher returns than the interest paid. So what could be more obvious than declaring the dividend the new interest rate?
It sounds totally simple. I buy a stock that pays dividends or an ETF that pays dividends, and I get regular cash inflows into my account. It's tangible, it's quickly explained, it's easy to understand, and it's a story that can be told. As the amount invested increases, so do the dividends. More money in, more money out. Zack, another story that can be told and shared on getquin in droves.
getquin gives us the opportunity we all know to share our portfolios with other investors. One combination of words is sometimes read very often in the requested feedbacks. The talk is about the desire for "monthly cash flow". Without exception, people try to achieve this monthly cash flow by means of dividends. Why one has nothing to do with the other, and which pitfalls are waiting for you when investing in high-dividend stocks, I would like to explain step by step.
So let's start by pulling a few teeth.
🦷#1 - Dividends are free money
The dream of passive income, getting money for doing nothing. Or at least sit down once, make the effort and collect money afterwards with a clear conscience. That is the goal of many investors. How convenient for us are the dividend-paying companies, because if I am invested in the company anyway and take the price gains with me, then I take the additionally paid dividend with me. The fact that dividends are by no means free money is shown by the fact that the total return of a share price consists of two components:
Price yield + dividend yield = total return.
Example:
If a share has a price of 100€ and has paid out 5€ in one year, i.e. a dividend yield of 5%, as well as a price increase of 10%, the total return is 15%.
The same share would also make a total return of 15% without paying out dividends, except that the dividend yield would then be 0% and the price yield 15%.
In both cases, €100 later became €115, except that in one case a portion is paid out, and in the other case the money stays in the company.
Psychologically, we like the first variant better. Technically, it makes no difference.
This is because both the price yield and the dividend yield originate from the same pot of the company: the profit. Even if the company does not pay out the dividend, it still remains part of the profit and will be reflected in the price yield.
So to claim that dividends are free money is not true, because if you turn the above logic around and keep the payout for yourself without reinvesting it, it clearly comes at the expense of total return, which means that the bottom line is that assets grow more slowly. So we pay for the dividend at the price of no return.
Reinvesting dividends. That leads us directly to the next tooth.
🦷 #2 Once I have received dividends, no one can take them away from me
This statement is quite true. The money goes into your clearing account, so now it's yours. But now it is absolutely crucial what you do with it. If you leave it in your account or even use it to pay your gym dues, you're diminishing your return. Why? Because we 🦷#1 already learned that without a dividend yield, all that's left is the pure price yield. If that's not high enough, or if the dividend yield discount is very large anyway, it has a significant impact on our wealth accumulation.
ExampleAllianz
Let's look at the past year 2022 of the Allianz share. Without reinvested dividends, the share price performance was -3.3%. With the reinvestment of the dividend, however, it is +2.0% [2]. So whether we use the dividend for the gym or put it back into the portfolio is the difference between winning and losing, even over a one-year period. With a long investment horizon, the lower compound interest effect is even more noticeable.
As long as you have not reached your financial goal, you should not think about using the dividends for something else than putting them back into the portfolio. If you reinvest the dividend in the same stock, you're giving it away again and transferring it back to the company. So yes, a dividend paid out is yours, but you still shouldn't keep it for wealth accumulation.
🦷#3 The higher the dividend yield, the better
Every serious dividend investor knows that dividend yield is not the only factor when it comes to selecting dividend stocks for a portfolio. But why should it be? A guaranteed yield of more than 10% sounds tempting.
The dividend yield is made up of the dividend agreed at the last Annual General Meeting and the current share price.
With a distributed dividend of €5 and a share price of €100, we have a 5% dividend yield. If our share gets into difficulties and loses 50% of its market value, the dividend yield is suddenly 10% at a price of 50€. Now we have to analyze carefully why the share has such a high dividend yield and whether the price loss behind it is to be taken more seriously. No one wants to put their money into companies that are doomed, even if they receive promising payouts in return. In the event of a sustained share price loss, a reduction or cancellation of the dividend in the near future is not out of the question, but very likely.
🦷#4 Dividends are a secure passive income
Let's get to the point where we take apart the phrase "dividends are the new interest" mentioned in the introduction. While, at least with fixed income, interest is secure over the agreed period, dividends are not at all. While it is possible to make deductions for the future from the past, none of them can be considered set. Dividends are paid voluntarily by the companies, the shareholder has neither a claim to continued payment, nor can he prevent a reduction or even cancellation if decided by the company.
Thus, there is a clear difference in the beneficiary's claim between interest and dividends, but also the risk level of one's own asset allocation takes on a whole new level if one tries to equate dividends with interest.
This circumstance can, but does not have to, lead to the fact that a surely expected payout is reduced or does not take place at all, which of course has an impact on the already accustomed monthly cash flow.
🦷#5 It is the same whether I accumulate or reinvest the dividend itself again
Not quite true. Accumulation and reinvesting dividends are not the same thing. Since taxation is handled differently with reinvestment than with distributors, there are advantages and disadvantages here as well.
Until 2018, an accumulating ETF could benefit enormously from the so-called tax deferral benefit. Due to the fact that until 2018 no capital gains accrued during the term of a reinvesting ETF, the complete gross dividend was reinvested and the maximum benefit from compound interest could be gained. The taxation was only due upon sale and was thus deferred, i.e. deferred.
The introduction of the advance lump sum has put this into perspective to a certain extent. Nevertheless, the tax burden of the reinvestor is lower.
Below the tax-free amount, it really makes no difference whether you are a payer or an accumulator. Everything that accrues in dividends ends up 1:1 back in the ETF, in both cases.
The situation is different above the tax-free amount.
Distributing ETF:
Deposit value 01.01.: 100.000€
Deposit value 31.12.: 110.000€
Price gain: 10.000€
Dividend yield: 2.01%
Dividend paid: 2.010€
Total return: 12,01%
Total profit: 12.010€
Taxes to be paid (70% of the dividend paid): 1.407€
Taxes payable (26.37%): 371.03€
Net dividend available for reinvestment: €1,638.97
New deposit value: 111,638.97€
Increase in value: 11,638.97€
Accumulator ETF:
Deposit value 01.01.: 100.000€
Deposit value 31.12.: 112.010€
Total return: 12.01%
Total profit: 12.010€
Advance lump sum 2023: 1,785%
Base income: 1.785€
To be taxed (70% of the base income): 1.249,50€
Taxes to be paid (26.37%): 329.49€
New deposit value: 111.680,51€
Increase in value: 11.680,51€
The accumulator therefore remains at a slight advantage when it comes to long-term wealth accumulation. The difference in what remains after taxation, with the same price gains and yields, is about 42€ for the accumulator with a securities account value of 100,000€. The selected dividend yield corresponds to that of the FTSE All World Dist.
In the whole calculation, the amount of the upfront lump sum or the underlying prime rate plays a decisive role. In recent years, this has even been negative, so that the upfront flat rate was not applicable. According to Finanztip, an average upfront flat rate of 1.5% is realistic, i.e. slightly below the value used in the calculation for 2023.
We can also swap out other variables in the equation and look at a high-dividend ETF. The taxable portion grows, the price return suffers, as the comparison of the FTSE High-Dividend Yield with the FTSE All World shows.
That's why I would advise anyone with a high-dividend ETF in their portfolio today who is not reliant on monthly cash flow and has an investment horizon of more than 15 years to reconsider this investment.
🦷#6 Dividend payments do not eat into the substance of the portfolio
Let's get to the most important point of the list and the hook of this post.
"Dividends are not necessary for monthly cash flow". Why? Because both dividend payments and the sale of shares eat away at the substance of the portfolio. Why is that?
We are fast-forwarding a few years into the future and are now approaching retirement. As of now, we want to reap the rewards we sowed the decades before. Our portfolio has reached a value of 1,000,000€ and we are looking at two withdrawal strategies. On the one hand we improve in account A our pension with 2% dividend payouts and on the other hand we sell in calculation B we simply sell 2% shares on a regular basis. In a first consideration we leave out taxes and transaction costs. Later I will go into this again.
Calculation A
Deposit value beginning: 1.000.000€
Number of units in the depot: 10.000 units
Unit value: 100€
Distribution (2%): 20.000€
Distribution per unit: 2€
Unit value after distribution (dividend discount): 98€
Number of units after distribution: 10,000 units
-> Deposit value end: 980.000€
Calculation B
Deposit value beginning: 1.000.000€
Number of units in the depot: 10.000 units
Unit value: 100€
Withdrawal via sale of units: 20.000€
Number of units sold: 200 units
Number of units after withdrawal: 9.800 units
Unit value after withdrawal: 100€
-> Deposit value end: 980.000€
In both cases, i.e. dividend distribution as well as withdrawal by sale of shares, our deposit value decreases. The previously mentioned drawn teeth are also included in these findings. Dividends are not free moneybut part of the company's profit, which is simply not returned to the company but paid out. The dividend discount ensures that our shares become less valuable and if we do not compensate for this by reinvesting the dividend, our portfolio loses substance.
From the point of view just considered, it does not matter whether I realize my monthly cash flow by dividends or replace it by manual withdrawals from the portfolio. This consideration was listed by Messrs. Franco Modigliani and Merton Miller as early as 1961, and provided as an explanation why dividend policy is irrelevant to corporate value. A dividend payout could be replicated by the investor at any time and thus a so-called Homemade Dividend Policy could be implemented [5]. The gentlemen received the Nobel Prize in Economics for this work, among others.
But what about when we take taxes and transaction costs into account?
One thing to start with: I am firmly convinced that there will be some changes in the next 30 years as far as taxation, transaction costs and the sale of shares are concerned. Almost certainly, in the future, we will have the option of investing withdrawal plans with our broker. As we currently have monthly besavings, we will also be able to entsave. This means that you don't have to be active yourself every month or every quarter.
What about taxes?
Taxation will change, but let's look at the current situation: 26.37% flat tax on capital gains and partial exemption on equity ETFs. In addition, an allowance of 1000€.
Does it make a difference whether I receive dividends or sell shares? No.
We pay taxes on capital gains. Both dividends and the sale of shares fall under capital gains. Of course, we cannot compare apples with oranges and assume the distribution/withdrawal from an ETF. Individual shares are therefore excluded. Again, the partial exemption applies to both variants. Just like the tax-free amount.
From today's perspective, neither variant has any tax advantages or disadvantages.
What about transaction costs?
Dividend distributions do not incur transaction costs, while sales do. An advantage for dividends. But are transaction costs so high that they are the death knell for our monthly cash flow from sales? That will depend on the broker and on what else changes in this area in the coming years. Today, sales are already free or cost only 1€. With direct banks one is there fast with 1%-1,5% of the payout sum. Does not sound so beautiful. With the already presented withdrawal plans, however, this could (subjunctive!) be adjusted in one way or another. Savings plans to build up a portfolio also follow a different cost structure than one-time purchases. Of course, for 1€ transaction costs, inflation must also be taken into account, but I for my part consider transaction costs to be negligible already today, and even more so in 30 years.
To reduce transaction costs, one could also switch to quarterly sales.
Conclusion
This contribution was not entirely altruistic. I wanted to answer the question whether I will have to replace my initially selected accumulation funds in the near future. The sense of the dividend made sense to me, too, even though monthly cash flow has never appealed to me in any way. But it is better to think about old age today. In addition, the upfront lump sum brings a previously new component into play that disputes the tax advantage of accumulating ETFs over distributors.
With an expected average advance lump sum of about 1.5% (statement of Finanztip), however, accumulators continue to have the compound interest advantage over distributors. Optimal, therefore, and still the first choice for me when it comes to long-term asset accumulation.
And with the knowledge I have gained, I can now make withdrawals from the portfolio, knowing that dividends are technically nothing else. Psychologically, dividends may be motivating. However, seeing the portfolio value and assets grow is motivation enough for me.
There may still be changes coming in taxes and transaction costs, but even with today's option, there would be no significant downside.
So I have a conclusion for me draw a conclusion.
What can you take away from this?
A slightly different perspective on dividends!
Should you change your strategy now?
No. You should sit down and do your own calculations and research. In addition to the bare figures, your own strategy also includes your own psychology, risk tolerance and investment horizon.
Why did I talk about an investment horizon of 15 years at the beginning?
Within the next 15 years, I would expect the taxes and costs that apply today. To speculate on changes would be negligent. Since dividends do not cause transaction costs and I personally would not want to hold a million-dollar portfolio with a neobroker, I consider distributors to be the better choice for this situation.
With one, and especially myinvestment horizon of 30+ years, the situation is different. There I go with the Thesaurierer and the manual withdrawal. This is my personal assessment.
Thanks for reading!
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Sources
[1] Tagesgeld - Entwicklung des Zinssatzes bis 2022 | Statista
[2] https://www.allianz.com/de/investor_relations/aktie/kurs.html
[3] https://gerd-kommer.de/dividendenstrategien-fakten-und-fantasien/
[5] https://m.diplom.de/document/227062
[6] https://finanzbiber.com/dividend-fallacy/
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