Dividends vs Capital Gains

There are many people who claim that dividend investing is a bad idea because you end up paying more tax.

Although it depends on country, generally dividends are classified as income, and income is usually heavily taxed whereas capital gains are normally not taxed until you sell the investments. Investors typically sell all their investments when they retire. When investors retire, they are typically earning zero income (because they’ve stopped working), so any tax they pay as a result of capital gains tax is usually minimal.

If you invest in dividend-paying stocks, you are being taxed on those dividends, and in countries with progressive taxation, the tax you pay is usually very high because your salary from work is counted as income as well.

There is also an argument made that companies that pay high dividends sacrifice capital gains because money that the company pays out as dividends could have been reinvested back into the company for expansion.

One in hand is better than two in the bush

While these are all fair arguments, I still believe that investing in dividends is better even if you pay more tax. The reason is due to risk. A bird in the hand is better than two in the bush. When companies pay dividends, you get cold hard cash in your hands. If instead you sacrifice your dividends and instead allow the company to reinvest that money, you don’t know if that reinvestment will work or not. Most people employing a buy-and-hold strategy typically wait multiple decades expecting capital gains to accumulate throughout that time, and when they retire they sell their investments. However, if you wait three or four decades and amass large capital gains, what if, just before retirement, there is a very large global recession that sends asset prices down? Decades of work has been flushed down the drain.

Money printing, negative interest rates, automated trading, and high leverage have made capital gains unreliable

Dividends are simple. A company sells something, they make money, pay their expenses, and a portion of whatever is leftover is given to investors as dividends. Dividend payments therefore depend on the quality of businesses, the quality of their management, products, services, etc.

Capital gains, however, are completely different. In today’s world of constant money printing and stimulus and high leverage products that increase volatility, it’s hard to trust asset prices because asset prices can be instantly manipulated. Asset prices are now so divorced from reality that it’s difficult to know what real or fundamental value is. If a bubble never pops and is continually inflated, is it a bubble?

In my opinion, the lost two decades in Japan following the crash in its asset price bubble in the early ’90s will play out in Western countries. Japan was an economic leader but the crash of the ’90s was its peak, and since then they have simply tried to reinflate their economy with no success, and the economy has gone sideways ever since.

nikkei225-source
The Nikkei 225 since the ’80s

What has played out in Japan will play out in Western countries where peak growth has been realized. We will see a zigzag pattern as stock markets crash and then are reinflated before crashing again, and this continuous forever. The best way to make money in such an economy is to forget about prices and focus on dividends.

Dividends and capital gains are not necessarily a trade-off

Empirically, dividend-paying stocks don’t necessarily perform worse. Below is a chart of the S&P 500 index versus the S&P 500 Dividend Aristocrats index.

Dividend Aristocrats vs S&P500
The S&P 500 Dividend Aristocrats index vs the S&P 500

Source: https://www.indexologyblog.com/2014/12/12/inside-the-sp-500-the-dividend-aristocrats/

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