Finishing off the year with a few of my top episodes of 2023!
Thanks to all of you for being loyal listeners of the podcast.
See you with some new episodes in 2024
--
TAX CHANGES: Budget 2024
XEQT vs VEQT. Which ETF is better?
Add some STRESS to your retirement plan
Connect With Evan
Finishing off the year with a few of my top episodes of 2023!
Thanks to all of you for being loyal listeners of the podcast.
See you with some new episodes in 2024
--
TAX CHANGES: Budget 2024
XEQT vs VEQT. Which ETF is better?
Add some STRESS to your retirement plan
Connect With Evan
Hello and welcome back to the Canadian Money Roadmap podcast. I'm your host, evan Neveld. On today's episode, I'm excited to be joined by Mark McGrath. Mark is a financial planner and investment advisor at PWL Capital and you might remember him from earlier this year when he joined me on an episode to talk about corporations and investing for professionals. This week, we are changing gears a little bit and we're talking about dividends and why much of what you see on Twitter and YouTube about dividend investing might actually be steering you in the wrong direction and when you're building your long-term investment portfolio, we're going to talk about some things that you should be thinking about instead of focusing on dividends perhaps. It was a really fun conversation about some really practical aspects of investing and I think you're really going to enjoy it. So here's my conversation with Mark McGrath. All right, mark, thanks so much for joining me today on the Canadian Money Roadmap podcast. Thanks for coming back, I should say. Actually.
Speaker 2:Yeah, no, it's, that's crazy. You're back. Thanks for having me on again.
Speaker 1:Yeah, okay, well, time flies, but Mark was on the podcast back in February talking about corporations and things to keep in mind for professionals. That was a little bit more of a niche audience, but Mark is also someone who is an expert in all things investing. But in my lurking on Twitter I don't post a whole lot on Twitter, but I see what's going on there I've seen a huge increase in the number of accounts of people that are focused on dividends and how they're, you know, the singular path to wealth and all sorts of stuff, and I've also seen you chime in on a bunch of these posts, and so I'm like, okay, let's get work on here to talk about dividends that sound reasonable to you.
Speaker 2:Yeah, I chime in as uh as, probably putting it mildly. I think I've had some fairly epic battles with some of those. Those dividend accounts yeah, no, happy to discuss it. I think it's an important topic. I think lots of people are focused on dividends, whether that is a good idea or not. I think it's something we're going to talk about today, but I'm fairly passionate about the topic, so I'll try to, you know, temper my opinion on it.
Speaker 1:I love it, though I typically don't get too passionate or anything like that, so instead of lolling my listeners to sleep, we might get a little bit of a little bit of spice here today. This is good, so maybe let's just start off with high level concept. What are dividends? How do they work?
Speaker 2:Yeah, so dividends? Dividends are basically a distribution of a company's earnings or profits to its shareholders, right? A company is, you know, profitable and has cash, and the board of directors will determine a dividend policy for those companies that pay dividends. And basically the reason they pay out a dividend is that they don't have a better use for the money internally, right, they can't take that money, those profits, and invest it in a way that is acceptable. They can't earn a high enough rate of return on that money by investing it internally into, you know, say, new projects. And so they distribute those dividends to the shareholders, and usually that's done on a quarterly basis for most companies. Some ETFs and funds will have monthly distributions, some will have annual distributions, but if you're picking individual stocks, for the most part those are going to be quarterly and the board of directors sets a basically a dollar amount of what these dividends are, but they're most commonly quoted as a percentage of the current share price, right? So if you see a stock and it says there's a 4% dividend yield, all they're doing is they're just taking the dollar amount of that dividend yield and dividing it by the current stock price and, as long as you own shares of that company on what's known as the X dividend date, then you will be paid that dividend. So the X dividend date is basically the date by which, as long as you own the company, then you will earn the next dividend. So that's basically how they work.
Speaker 1:So dividends because they pay shareholders one of the common misconceptions that I see, or maybe not in so many words, but people kind of see dividends as like free money. It's like, yeah, if I own this, I just get this stuff for free and I don't have any risk along with it. Maybe can you address that common misconception or maybe some other common misconceptions that people have about dividends.
Speaker 2:Yeah, and you're right. A lot of investors I would say a lot of new investors specifically think that way. Like I don't know that any seasoned or professional investors really think that dividends are free money. But to the uninformed or uneducated or new investor, there's definitely that misconception, and I've had conversations with people about this online and on Twitter. So the dividends come from the company's value and this is very simple arithmetic that it still shocks me that I have to have this argument with some people, because it's very simple mathematics. If we have a company that is worth $100 and they pay out $1 in dividends, they no longer have that dollar. Cool, yeah, and so the company is no longer worth $100 because they've given away a dollar of their value of that company. So now the company is worth $99. It's that simple. The reason people, I think, have trouble grasping this is because when you look at the price of a stock on its ex-dividend day, it doesn't always drop exactly by the amount of the dividend, and of course, that's reasonable because there are millions of things that are moving prices in the markets on any given day and so, like in a vacuum, yes, you would see the share price drop exactly by the value of the dividend. But we don't see that live when you're watching markets and when you're looking at prices, because some other good news or bad news is also moving the price of that stock. So this idea, that is, some additional return that you get for holding the shares, is a very common misconception. So it's not free money and it's taxed. It's a distribution of the company's earnings and when you receive a dividend, depending on the type of account you're holding it in, it's taxable. So I think for a lot of investors who are holding dividend stocks in taxable accounts during what we call the accumulation phase of their life, which is kind of the wealth building phase before they've retired, they're electing to take on a tax burden and they're usually reinvesting the shares I mean the dividends rather back into shares of the company, which is kind of funny to me because they would have been just much better off not receiving the dividend and having the value of the dividend accrete to the share price instead. But they love their income.
Speaker 1:But it's also challenging because they're not electing to receive the dividend. You know what I mean. The company is sending it to them, but so, for that investor, they would be better off if the company made a different decision. Is that a fair distinction to make? Potentially, potentially, yeah, yeah.
Speaker 2:Assuming the company could reinvest that money at a reasonable rate of return, then yeah, the company would be better off keeping the cash and not distributing it. But I think you bring up an interesting point, because right now if I receive a dividend from an ETF, an exchange-traded fund that I own, I don't need that money right now. I mean my working years. I don't need that money to pay the bills, so it just automatically gets reinvested. I personally, as an investor, would much prefer they didn't pay me the dividend, but I leave that decision up to the board of the directors of the companies that they're running.
Speaker 1:Yeah, what if you're in an RSP or a TFSA and you receive that dividend? Is the immediate taxable income less of a concern in that regard? Is it just more of a mechanical inefficiency?
Speaker 2:Yeah, mechanical inefficiency is a really good way to put it, generally speaking. So for Canadian dividends, that's true, right, because investment income inside a TNRSP is not taxed. You don't receive it a tax slip at the end of the year for any distributions that you earned in those accounts. It's not really a concern from a tax perspective on Canadian dividends. On foreign dividends, it gets a little bit more complex than that and I don't know we want to go deep into the weeds on how foreign withholding taxes work because it's a pretty nasty topic. But effectively, in a TFSA you may pay some foreign withholding taxes on dividends received from companies outside of Canada, and in an RSP, depending on the tax treaty with the country where that stock is domiciled, you may or may not pay withholding tax. Like if you hold dividend stock in your RSP and it's a US stock, we have a treaty with the US, so there's no foreign withholding tax on that dividend. But it gets really messy because it depends on whether you hold the stocks directly or whether you hold a Canadian ETF that owns the stocks directly or a Canadian ETF that owns US ETFs. So the multiple layers of withholding taxes and the types of accounts that you hold these things in it does get pretty complex. So long answer to a short question. But generally speaking, for the listeners benefit inside an RSP and a TFSA. It is just a mechanical. What did you call it?
Speaker 1:A mechanical inefficiency? Yeah, beautiful, I love it. I came up with that on the fly. That's pretty good. Brilliant, yeah, okay. So that's one of the misconceptions here. What about things like yield, or maybe? I've called them yield traps in the past. Yeah, the trap is the leading term there. So if I'm looking for different stocks that I'm investing in maybe in different ETFs or whatever and I see a higher dividend yield, is that better or worse? How should we view?
Speaker 2:dividend yield? Yeah, it's a good question, and I think yield trap is a good way to put it. Now, it's impossible to say whether buying a particular stock that has a high yield is a good investment or not, right, Because that's just all going to depend on the future total returns that you earn for holding that stock. But I think a lot of investors see the yield as the return, Because they misunderstand this concept that when a dividend is paid to share, the company's value must drop by an equivalent amount. When they see a high yield, they do believe that's an excess return. Right, and so looking for companies or filtering companies or investments purely by the dividend yield can lead you to not only building a suboptimal portfolio, but it can also lead you to taking on more risk. Right, Because, if we go back to what we said earlier, the dividend is, I guess, advertised or decided on as a dollar value, right, and so if you have a really high yield, it's likely because the share price is really really low generally speaking, right? So if the share has dropped in value, that dollar amount of that dividend as a percentage of the stock's current price is going to be really high. And if you're buying stocks that have gone down a lot in value. There's probably some risk there that you're unaware of, but there's a reason. The market is pricing the stock that much lower right and dividends aren't guaranteed by any means. Right. Like a lot of investors, I think they see this yield and they think it's infinitely sustainable and there's no risk to that dividend. But companies cut dividends all the time Dividend aristocrats or kings or whatever they're called. They often not often, but there are absolutely times in history where those types of companies like GE and JCPenney like, cut dividends altogether and were dropped off of these lists. So buying it for yield is not a way to guarantee some sort of future income. It's not a bond where you know exactly what return you're going to get. It's not an annuity. It's your buying stocks that have likely gone down in value for some reason you're unaware of that are paying a high yield.
Speaker 1:Yeah, and you made a good point there about how the yield is determined, right, it's connected to the price, and the price is a significant part of your return for better or for worse, right? And so you know a total return from a stock would it be fair to say it's price plus dividend. And so if dividends go up and price goes down, maybe you're equal, and vice versa, and whatnot, right? So it's not a both and it's together, right, you have to account for them together. So when yield goes up, that can happen every day, right, because the or throughout the day, because these prices are moving throughout the day, and you know, if you're looking for yield and your stock price is appreciating, your yield is plummeting. Theoretically, right. And so if you're just looking at the yield of a dividend stock, you're like, oh my goodness, my yield is just getting evaporated. We're, in the meantime, you're making money, right, like you might be making suboptimal decisions on something that isn't relevant to you.
Speaker 2:Yeah, that's exactly right. Right, and I'm not saying that dividends aren't important, right, like I mean, every time I get into this argument with somebody, they pull up a chart and it shows the component of the S&P 500 returns that came from dividends. And the argument is what do you mean? Dividends aren't relevant. Look how much of the returns of the S&P 500 historically came from dividends. And that, of course, that's totally fine. Like, yes, the dividend is going to be part of the total return that you earn on a position over time or on a market over time. Right, the argument is you shouldn't select based on dividends. Like you shouldn't filter out half of the investable universe because they don't pay dividends and then try to filter stocks or investments just based on their dividend growth patterns or their dividend yield. Like there's no information on the future return of an investment based on what its dividend policy is. It's just not a factor in expected returns.
Speaker 1:Right, okay. Well, that kind of leads me to my next question here. So why do people love these things so much then? Is it just misunderstanding? Is there some sort of psychological benefit? What do you think?
Speaker 2:Yeah, I will admit that there's very likely a psychological benefit that is driving these decisions, and I'll admit it because I've had conversations with dividend investors and that is primarily why they tell me that they like this strategy is they focus on the income that they're receiving, not on the value of their portfolio, of the value of their shares, right? So most of the time when you're talking to dividend investors or you're watching YouTube videos of dividend investors, they're never talking about the value of their portfolio, their total historical returns or annualized returns. They're only talking about the projected dividend income or the dividend income received to date. And that's fine. But it's really just mental accounting. I think they're choosing to focus on the income stream, which probably allows them to sit through that volatility of the actual balance of their portfolio a lot more easily. Right, like in a bear market, their portfolio might be down call it 30, 35% they might be less worried about that. As long as the dividends aren't being cut right, they're still getting their paycheck quote unquote. So if it allows you to sit through a really volatile market without making a devastating mistake like selling at the bottom, then I can reluctantly admit that perhaps dividends do have a benefit from that perspective.
Speaker 1:I was kind of baiting you into admitting that there might be something there.
Speaker 2:No, no, for sure I know, I do admit it.
Speaker 1:No, but I'm not a big dividend proponent as well, but I totally see that it's like the idea of the burden the hand is worth two in the bush Like. People see price appreciation as this fleeting concept that's based on nothing, which isn't true, versus income that's in their account every month or every quarter, whatever the case may be.
Speaker 2:Except for then they reinvested into shares of the company anyway, but yeah.
Speaker 1:This same company, yeah, yeah. So do you see that as maybe in your searching, or maybe you do a little bit more research on these dividend accounts on Twitter and whatnot, Are they typically doing that? They're just doing they're setting up a drip like a dividend reinvestment plan, or are they people using dividends Like I've heard of people? Sorry to keep rambling here. I've heard of people wanting to do like an ESG focus? That's another question for another day, but like an environmental social governance strategy and they'll own the cigarette companies and they'll own Exxon Mobile and whatever, and it's like these are the terrible companies, but I'm gonna take their dividends and I'm gonna buy other stuff with it. It's just kind of like Robin Hooding, like some good out of the stock market, taking from the evil and whatever.
Speaker 2:Do you see that?
Speaker 1:kind of thing happening from time to time, or is it typically just like drip and I'm just gonna get my Chevron dividends?
Speaker 2:I've seen both, like I haven't seen that specific example where they're trying to invest in a socially responsible way using the dividends. But I have seen exactly what you're talking about, in that they take the cash from the dividends and then they make a decision on how to invest that cash, whether it's buy more shares of the same company or allocate that cash to a different part of their portfolio. So when you're accumulating wealth and you're getting these cash distributions and then having to make a decision on what to do with the money, it is functionally equivalent to you owning a stock that didn't pay a dividend and you are electing to sell shares of the company to do something else, Like you're just actively managing your portfolio in disguise. So when a company pays you a dividend, they're just giving you some of the value of your company back. If you and I own the same portfolio, it's got the exact same value, the same expected returns, the same fees and everything. But mine pays zero dividends and yours is a dividend portfolio. I can choose to sell parts of the positions in my portfolio and reallocate that cash elsewhere.
Speaker 1:And that's all dividend investors are doing, if I want to.
Speaker 2:But that's the nice thing is, I have control over that decision, whereas with the dividend portfolio you're leaving that up to the board of directors to force a distribution onto you and then you're required to make a decision every single quarter or every single month, depending on the product. So I have seen people do that and again I think it's just mental accounting, like you can just sell shares and reallocate if you want to.
Speaker 1:Right okay, so we're gonna eat it here. Yeah, here we go, we're going. So now this is the million dollar question, and maybe I can let you cook on this a little bit too of okay, focusing on dividends, especially focusing on yield. It's not an optimal way to invest, by pretty much any definition, the way that you look at it. What is a better way to invest?
Speaker 2:Yeah, so that's a big question, right, you know, without talking specifically about like an individual, because how you build your portfolio is going to be determined by a number of factors, including your time horizon, your risk tolerance, your risk capacity, et cetera. We know that as advisors Hopefully the listeners know that after listening to your podcast for a long time, so I won't say to anybody here's how you should invest your money. What I will say is that if you're building a portfolio and you're looking for the factors that drive performance in diversified portfolios in diversified portfolios, rather, dividends are not one of those factors I think most people would do well by holding a broadly diversified portfolio of global stocks and potentially bonds, depending on your risk tolerance, for a low fee, your classic market cap weighted index portfolio. Most people would do well to do that and ignore whether or not a particular like, ignore the yield on whatever ETF you're buying in order to accomplish that. If you want to take it one step further, I think you've talked about factors on your show before. 95% of the differences between two diversified portfolios, 95% of the difference in performance, rather can be explained by that portfolio's exposure to risk factors that we know about, which are size small cap versus large cap, price, which is value versus growth, profitability and what's known as investment, which is a company conservative with their investment capital or they aggressive. Basically, what we see is that dividend stocks, especially dividend growth stocks, do tend to have some of those characteristics. They're usually value stocks that are profitable and have conservative investment Because they're giving you the money. Well, yeah, that's another argument is that by having a dividend policy, management is forcing themselves to be more prudent or more conservative with their capital, knowing that they have a dividend to pay out. I think it's a reasonable thought but at the same time, companies can be conservative with their investments without having to distribute capital. You should care about the investment policy of the company and not about their dividend policy. If you can get a portfolio that loads on those factors that I just discussed and ignore dividends, you should in theory, have a better outcome, simply because you'll be more diversified. You're getting effectively the same expected return, but with lower risk because you're more diversified. But that's getting fairly complex, like the ability to implement factor portfolios, I think for most people is beyond them. You'd have to work with an advisor that knows it or you'd have to be really interested in this space, like there's a few ETFs, but it's really complex. I think one of my now colleagues wrote on one of their blogs one time the number of clients that I have that failed to meet their financial goals because they didn't implement the factor portfolio and actually just held a cap weighted index portfolio the number of clients that failed to meet their goals because of that is zero.
Speaker 1:When you look for factors or even invest in an index style, you're not saying that companies that pay a dividend are garbage and not worth owning, because those portfolios are going to own dividend paying stocks anyways. It's just not the criteria that selected them for the portfolio in the first place. Would that be fair to say yeah?
Speaker 2:That's usually my favorite comeback in these dividend arguments is I own all of the dividend stocks, every single one. It's not that I hate dividends. I just don't think they're useful in building a portfolio as a criterion for selecting or filtering from a list of potential investments in your investment universe. So yeah, if you're going to own dividend stocks, you absolutely want the dividend. Of course it is an important component of the returns of a stock over time. It's just that you shouldn't necessarily cut half of your investment universe out just because they don't pay a dividend. I want to own all the stocks because I don't know where the returns are going to come from. I don't know which stocks are going to generate market beating returns over time, so I want to own all of them, whether they pay a dividend or not.
Speaker 1:Right and you talked about this before of making your own dividend. Can you explain that concept again?
Speaker 2:Yes, so selling shares is functionally equivalent to receiving a dividend, right? So if we walk through some fairly basic math, it's like a simple example is there's two companies, let's say you and I each have our own company? Right, we've got, say, evan Coe and Mark Inc. Both of our companies are identical. We're both great advisors, we've got the same types of clients, the same fee structures. We're literally identical in every single way, except for your company pays a dividend, because mine certainly wouldn't and I don't pay a dividend. And let's say that each of our company's value is $100. To keep it simple, you distribute a dividend for $1 to your investors. Now, your investors, before tax, now have a share worth $99 and they have $1 in cash. Their total wealth is still $100 before tax. Because dividends are tax my investors, I decide not to distribute a dividend. My investors own shares worth $100. They could elect to sell shares and just create that $1 dividend for themselves and they would be in the exact same position as your investors would. They'd have $1 in cash in this example, and they'd have a $99 worth of shares. So they'd be in the exact same position. The difference is that they have control over the timing of the distributions they can control when they want to sell those shares. So when you've got dividend income coming in, maybe it's more than you need to spend and you don't actually need it, so you're forcing a tax event on yourself. But also what's interesting is that people tend to adjust their spending to the income that they're receiving from the portfolio, and so people will. They're sensitive to the amount of dividends they get when it comes to their own consumption and spending, and so if you have more dividend income in one quarter, you might actually increase your spending. And when it comes to retirement planning, that is not a great way to design a retirement portfolio Like. The sustainable withdrawal rate on the portfolio has nothing to do with the dividend yield and everything to do with the volatility of the portfolio, the total returns you earn over time and your spending rate. So if receiving dividends forces you to increase your spending, that's actually a bad thing, because for my shareholders, they can spend what they need to spend when they need to spend it, and it can still be very, very tax efficient.
Speaker 1:Right. Okay, we can get into some like planning concepts there too, cause, like if someone's in an RSP. I explain RSP is like a bucket. Once you get into retirement or beyond age 71, your bucket now is a hole in it and now it's called a RIF, a register of retirement income fund, and that hole can never be plugged. You have to take money out of it every month. So if you're investing in, say, dividend stocks, it doesn't really matter, because you're forced to take out at least a set amount of money that's prescribed to you by your age and the account value at any given time. So determining how much you're going to spend or whatever, based on the dividends you're receiving is crazy, because you might have to sell shares anyways.
Speaker 2:That's a great analogy, right? Specifically the bucket with the hole in it. I love that. I'm stealing that. I'm going to use it now with clients. Thank you for that. But also to your point, right. I mean, the cash distributions occur inside the RSP. They don't go directly to your bank account. With a non-registered or taxable account, often retired investors will have their dividends set to go into their bank account, and that's what I mean when I say they can be sensitive to their income and increase their spending. But to your point, with an RSP, that money is going to be distributed and it's going to stay in the RSP or RIF, rather. And then the amount of money that you take out of the RIF the minimum elise is determined by your age and a percentage. But it does create some sort of separation there. I think there's kind of a barrier between the income you're receiving from the dividend portfolio and the amount you must take out. So designing your income stream for retirement based on the dividends received A, it doesn't make sense. But B, when it's in an RSP, it's just completely irrelevant, right.
Speaker 1:Yeah, I was thinking about the other retirement issues because a lot of people, or maybe the content that I see anyways- is like, yeah, I'm going to build up my dividend portfolio for retirement. People don't say I'm going to do it to optimize my wealth or whatever it's like. I'm going to live off the dividends right, this language. And so you talk about some potential risks with that. But I see, in retirement anyways, two factors that are probably the most important to people's income, or maybe not most important, but tax, like minimizing tax bill over the course of your life dividends force upon you the tax bill in a non-registered account. And then flexibility of income. So I see people that are like, okay, well, I need to spend like four grand a month or whatever, but I want to go to Australia oh, we just got in a car accident. A new car, all these different things, any new flexibility of income. So you're in the position where you're probably going to need to sell some shares and keep in mind both tax and flexibility anyways, right. So I would say that the argument to focus your accumulation phase based on a dividend structure that probably won't be relevant or perhaps detrimental to you in retirement isn't a great option. The idea of you should start the way that you want to finish. You know, if you're in retirement and that is your situation. It's not going to be optimal. It's going to be less tax efficient than you think and starting a way that prioritizes more tax efficiency and flexibility might be a better way to go.
Speaker 2:But I think not only that, but what a lot of dividend investors maybe don't realize is that there's one account and won't name names or anything. There's one particular dividend account that I interact with, let's say, quite frequently, and they're constantly talking about their dividend income and how they've grown that over time and now they've got X amount of dividends per year. And my whole argument is look, if I have the same amount of capital as you do, tomorrow I can go and buy the exact same dividend yield that you're getting on your portfolio, right, like you've built it up over 20 years and now you've got a portfolio worth and I don't know the portfolio value, so I'm literally making up numbers here but let's say you've got a $2 million portfolio and the yield is 4%, and so it's paying you $80,000 in dividends per year and you feel that you've built up that income over time by accumulating these dividend stocks. Right, I can build up a $2 million portfolio by focusing on a low cost total index fund over time and then I can literally just go buy your portfolio with the same amount of capital and have the exact same outcome, like I can just go and buy that $80,000 income stream, so you don't need to start building a portfolio today so that you have a dividend portfolio in retirement. All that matters is the total return that you earn on your investment along the way, and then you can literally buy the same outcome right.
Speaker 1:So I've seen this terminology before, which I think is more interesting than it is actually beneficial or instructive for anything but the idea of yield on cost. I'm so glad you brought this up. Does this lead people to make suboptimal decisions? Yes, I've been leading you there.
Speaker 2:You are. I'm glad you brought it up and I did get into a conversation about this recently on Twitter as well. So yield on cost it's a fantasy metric that means absolutely nothing, it's totally irrelevant and it's meaningless At the end of the day to the listeners. Yield on cost I think the reason people love it is Warren Buffett references sometimes in his shareholder letters on his yield on cost for his Coca-Cola shares. So the idea being, if I put, let's say, $1,000 into a stock today, in 2023, and it pays a 4 percent yield over time as that position grows and compounds and I reinvest those dividends, let's say that it grows to $1,000. So it goes up 10 times over many, many, many, many years and once it's at $1,000, if it pays the same percentage yield, it's paying me $40 a year in dividends at that point. So now it's worth $1,000, it's a 4 percent dividend yield. I'm earning $40 a year in dividends. But my original position years and years and years ago, I only put $100 into it. So my yield today, when my portfolio is $1,000, I'm earning $40 in dividends per year versus the amount I invested of $100. My yield on cost is 40%. So what they're saying is now that $100 investment pays me a 40% yield at some time in the future. Right, who cares? It's totally irrelevant. Like I don't know. I could do the exact same thing with a company that doesn't pay a dividend. So let's take the exact same example. And that company, at $1,000 now in my position, is growing at 10% per year. So when that company goes up $100, I can't go back. I can, but it's meaningless. I can't say well, look, I earned $100 in growth on this position and my original investment was $100. So my growth on cost is 100%. This is how compounding works, people. It's got nothing to do with yield on cost or anything else. It's just how compounding returns works over time. And the problem is people then don't want to dispose of these positions that they have because they're referencing this metric that, in their mind, is meaningful. But at the end of the day, the example we just talked about applies You've now got $1,000 in a position and it's paying you 4%, so you're getting $40 in dividends. I could just go take $1,000 and buy that position two day and have the exact same outcome as you. The yield on cost means nothing. Well, ok, that's great.
Speaker 1:How long did you see that?
Speaker 2:I see it in dividend circles all the time.
Speaker 1:Really.
Speaker 2:OK, yeah, it's an anchor metric that people are using. Again, I think it's a psychological thing. I will admit that there may be some psychological benefits to using these types of metrics to keep you in good positions that you might otherwise sell in a bad market, but I think the other side of that coin is it prevents people from rebalancing their portfolio or selling positions that might not be optimal, because they're looking at this yield on cost and saying, well, this is a great investment, even if my total returns over time are lower than the market.
Speaker 1:Right, yeah, it could lead to over-concentration at one's own detriment or increases risk, then accordingly. So if people are going to still focus on this because closely held beliefs die hard. So I had somebody tell me one time when I was in university you have to misunderstand me correctly. So it's like if you're going to misunderstand and still take this as you should be investing in dividend stocks, what are some things to keep in mind anyways for people to do it safely, or anything like that.
Speaker 2:Yeah, yeah, I think the number one thing is diversification. When you pick stocks, when you go and decide that you're going to pick individual stocks, you're not actually increasing your expected return, you're just concentrating your portfolio, and so you can actually diversify all those risks away by having a diversified portfolio that has the same expected return as a concentrated portfolio. And so, number one and this is foundational stuff like be diversified. And the easiest way to do that is to buy a product like a fund or an ETF, an exchange-traded fund or an index fund that follows some sort of dividend index, like in the US and in Canada there's dividend growth ETFs and it's going to be a one-stop shop to getting a more diversified portfolio than you going and selecting individual stocks yourself and then trying to manage that, manage the rebalancing and everything else. So, number one if you're going to do this, stay very, very diversified. Be mindful of your fees, of course. Try to keep your fees as low as possible. I will say beware of all of these new products that are coming to market. Like yield is in demand, and has been, I guess but funds and companies respond to investor demand and the attention that they get, and so they launch products that are designed to capture investor dollars and nothing else. I won't name names, but there's a lot of new funds on the market that are advertising 13% yields. Actually, I will name names. There's a Tesla ETF that all they do is they own Tesla and they sell options on it for yield, so they create an income just off of Tesla, and it's now in an ETF. Like these things are designed to separate you from your money and pay fees. They're not predatory, but, at the same time, they're not some free money. It's not some new product that didn't exist before that. Now, all of a sudden, because you own it, you're going to beat the market over long periods of time. So beware of all of these new products that come out just advertising yield, as you mentioned it before. Watch over yield traps. Like you shouldn't be selecting products based on the actual percentage yield. You should be selecting it based on other factors. So don't just go and buy an ETF because it has a very, very high dividend yield. Be mindful of taxes. Right, we talked a little bit about taxes, but be mindful of taxes If you do want to get really into the foreign withholding tax thing. My now colleague, dan Bordelotti, and Justin Bender, who you probably know of as the Canadian coach potato and the Canadian portfolio manager. They've written a lot on this idea of foreign withholding taxes and where you might want to hold or the impacts of different types of stocks and ETFs and different account types. If you just Google Canadian couch potato foreign withholding tax explained, they've done a much better job than I can do in explaining that. So be mindful of taxes and go read that post for more, and I think that's about it.
Speaker 1:Diversification was the big one that I was probably 100% and it's possible. You know what I mean. If this is still something that is really going to scratch you rich and you're going to stay invested with it, it's better than you sitting on the sidelines and doing nothing. But make sure diversification is the box that you take, and it's very easy to do that. Even if you like an active strategy, you can still do that. But with an active fund that someone's going to do it for you, that's got more time, temperament, talent to do it. That doesn't mean it's going to outperform or anything like that, but at least it's diversified, instead of you just buying all three big Canadian banks and an oil and gas company.
Speaker 2:It's like, ah, come on. I saw a portfolio the other day that was 10 stocks, I think, and 70% of them were Canadian banks. So that's a dividend portfolio that is designed only for dividends. Massive concentration risk, and the banks are not doing very well right now. Based on the past few months, I'm not making any predictions about what that particular sector is going to do or not, but you've now concentrated your wealth into one sector of one country's economy, explicitly for the dividends. So you just end up taking all this risk that you don't need because, to your point, you can diversify it away.
Speaker 1:Cool, I will leave the last thoughts with you here, mark. Are there any points that you wanted to make before we close off?
Speaker 2:I think we covered a lot of it. I will say I mean, some people love this stuff, right, they love analyzing companies and that kind of thing. No-transcript, that's fine, that's great If you just really love doing research and building portfolios. I'm not here to tell you you're doing things wrong. Where I get concerned is the amount of misinformation that goes out to new investors on this topic and that do chase yields and they chase dividend stocks because of some of the misconceptions that we've talked about. The audience I'm talking to, I think, are those who maybe don't know what they don't know. Again, there's a lot of newsletters out there, a lot of YouTube channels that are focused on this topic and aren't explaining some of the risks, some of the downsides. So just be careful who you listen to. I'll bring up one more point, one more point that I think is actually really important. Oftentimes, people don't want to sell shares of a stock when the markets are down. I don't know if you've talked about sequence of returns risk before on your podcast, probably.
Speaker 1:I think. So I'm almost at 100 episodes. I don't even remember all the things I've talked about, so that's come up for sure, yeah.
Speaker 2:I'm sure it has. So this idea that when markets are volatile, and especially when they're going down, by selling positions in your portfolio you're basically dropping an anchor onto your portfolio, you're pulling the value of the portfolio down by selling these positions, leaving less capital available for when the eventual market recovery comes. And this is true Sequence of returns. Risk is a problem for retirement planning, for sure. And the argument that I often come across is well, I don't want to sell shares when the market is down, but I can just hold my shares and get paid and get my dividends. It's the same thing when a stock is down in value and it pays out a dividend, the stock drops by the value of the dividend. It's equivalent to you selling shares. So the sustainability of a portfolio in a bear market has nothing to do with whether or not a company pays the dividend or whether you sell shares in a bad market. So this idea that dividend investing is defense against bad economic times, there's absolutely no basis for that. That I'm aware of, and I think the arithmetic on that is pretty clear. So now again, though, I will say, psychologically, if it stops you from selling when markets are down, okay, I think that's a valid argument, but I think it's the only valid argument that I can think of. And if you can, just you know if your risk tolerance is sufficient. You can just not pay attention to your portfolio. Your time horizon is long enough and you can avoid making that mistake, regardless of the construction of your portfolio, you'd be better off.
Speaker 1:Yeah, you make a good point there, because it's not like the companies that are paying dividends in a down market are the only profitable companies, are the only ones that are making sales. It's like, ah shoot, netflix is down 30% and they're not paying a dividend. It's like they got billions of revenue. It's like you know what I mean. It's like you're still choosing to sell Netflix is probably a terrible example there but like any company that you would choose to sell, that's down, that doesn't pay a dividend. It's irrelevant because irrelevant because what are we doing at the end of the day, when we're owning stocks, we're owning a piece of a business that's actually selling products and services. To your initial point, do you want the exclusive party that returns that you're focusing on to be determined by the board of directors of those companies? Or do you see yourself as an owner of businesses for a really long time that are going to do a lot of good work, selling products that you know, love and trust.
Speaker 2:So anyways, that's yeah, no, you're. You're right, and I think part of that, part of the issue there is that you know, dividend good dividend stocks are good stocks in general. When they go down, they typically recover over time. I mean a lot of stocks that go down. They just never recover, right. But if you're going to take the example of two stocks that drop in value and you expect that both of them are going to recover, the argument that I hear is that well, I'm getting paid, so I'm getting the dividend and the stock is going to recover. So not that it's free money, but it's different than selling shares, right? The problem is, if you agree with the very simple math that when you pay a dividend out of a company, the company is worth less. If both companies let's say they both compound at 10% after that and they both get back up to break even at some point, the company that paid the dividend is going to have a lower share price to start that 10% compounding per year and should take longer to recover than the company that didn't pay the dividend. Right, and so it's no, it's no different than me selling the shares at the bottom and having less capital to compound to break even on my portfolio.
Speaker 1:So that's interesting. I haven't really thought about it that way. But it's a base rate problem, like it's just a percentages problem right, it is.
Speaker 2:It's very simple math. We don't see it because markets are so volatile and you're looking at them and news is moving markets at all times, so you're not seeing this like actually happen. It's a perfect example on paper, right? But theoretically and empirically I guess this is really what happens. But companies will say, well, when this company pays a dividend, I notice that it recovers its share price, usually within a few weeks or something like that. Right, and that's probably true. But if they didn't pay the dividend, they would probably recover their share price in a few weeks, minus a couple of days, because they didn't distribute part of the value of the company and drop the share price further at that point, right, yeah right.
Speaker 1:Interesting Mark. This was awesome. You mentioned being careful about who you listen to. People want to listen to you more. Where do they find you?
Speaker 2:Yeah, so I'm still very active on Twitter at Mark McGrath CFP. I'm on LinkedIn a little bit. I'm now on another podcast called the rational reminder podcast. I'm there biweekly now just for just for a few minutes doing some segments on financial planning for Canadians. You just Google me. I'm available If anybody has questions. I'm always happy to chat with people out there.
Speaker 1:Awesome, Mark. Thanks so much for joining me today. Really glad to have you on.
Speaker 2:Likewise Thanks, Evan.
Speaker 1:Thanks for listening to this episode of the Canadian Money Roadmap podcast. Any rates of return or investments discussed are historical or hypothetical and are intended to be used for educational purposes only. You should always consult with your financial, legal and tax advisors before making changes to your financial plan. Evan Neufeld is a certified financial planner and registered investment fund advisor. Mutual funds and ETFs are provided by Sterling Mutuals Inc.