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Dividend Reinvestment FAQs

I thought I’d do something different with today’s article. Below are a few questions — from different readers — about various aspects of reinvesting dividends. None of them required a long enough answer to constitute its own article, but the topics in question are likely to be of interest to other readers.

“I’ve read that from 1960 until now, 82% of the stock market’s overall return is from reinvesting dividends. But I’ve also seen that dividends are usually only 2-3% in a given year, whereas the market’s overall return might be something closer to 8%. I guess what I’m asking is why are dividends so much more important than the increasing price, even though they are a small part of the return?”

It’s not that the dividends are more important than the price appreciation. It’s simply that they are a significant part of the return, and leaving off a significant part of the return dramatically reduces the overall accumulation over an extended period. (This is the same reason that mutual fund expense ratios are super important.)

The longer the period in question, the more pronounced this effect. For example, a $1 initial investment that grows at 8% per year for 75 years will come out to about $321. Reduce the return to 7% instead, and the final result is just $160. In other words, reducing the return by one eighth cut the final value by half. If you instead reduce the return from 8% to 6%, you end up with just $79 — a one-quarter reduction in return reduced the final value by more than three quarters.

That’s why when you read about statistics regarding the importance of dividends over several decades, you see very pronounced effects. Any change to the rate of return will have a magnified impact on the ending value. The effect is smaller if we look at periods that are shorter but still significant over a person’s lifetime (e.g., 20 years).

To reiterate, dividends are important, because they are a significant part of the overall return. But the idea that they are far more important than the price appreciation is simply a misunderstanding of the math involved.

“Why does the price of a mutual fund fall when it pays a dividend?”

In short, the price falls because the fund has less assets, which means it’s less valuable. (The same thing happens with individual stocks, by the way.)

For example, imagine that a fund has a net asset value (NAV) of $25 per share on a given day, made up of $24 worth of various stocks holdings and $1 of cash. Then the fund declares a $1 cash dividend.

Anybody who buys the fund before the ex-dividend date will essentially be getting $24 worth of stocks and $1 of cash. Anybody who buys after the ex-dividend date will be getting just the $24 worth of stocks. Point being: the price should fall by $1 on the ex-dividend date. (Of course in the real world it’s messier than that, because the prices of the various underlying stocks would also be moving around from one day to the next.)

To be clear, the fact that the price falls on the ex-dividend date doesn’t mean that you lose something when your fund declares a dividend. The price falls, but you now have an equivalent amount of cash in your brokerage account. (Or, if you reinvest the dividend, you’re in exactly the same place as before, tax considerations notwithstanding.)

“Should I set my mutual fund to automatically reinvest dividends?”

Maybe.

Having dividends automatically reinvested means that your money begins to earn a return sooner, which is a good thing.

But, if the account in question is a taxable account, it also means that there’s more tracking to be done, because you’ll have a greater number of dates and prices at which you purchased shares. But if you aren’t tracking your cost basis yourself anyway (e.g., you’re using the “average cost” method, and you are relying on your brokerage firm to calculate such for you), then the additional complexity doesn’t much matter. (To be clear though, I would encourage you to keep your own cost basis records, rather than completely relying on another party.)

You should also be aware that automatic reinvesting of dividends could result in a wash sale if you sell the investment in question at what would otherwise be a loss. Generally, this would not be a major reason not to reinvest dividends, as the effect would usually be small. But it’s something to be aware of so that you can report your taxes appropriately.

“How do I calculate the gain or loss on a sale of a mutual fund when I have had dividends and capital gains reinvested? Last year I invested $40,000 in a mutual fund, and it was worth about $40,500 at the end of the year. My dividends and taxable gains for that year, all of which were reinvested, were about $1,700 according to my online statements. Let’s say my fund’s value is $40,500 when I sell it this year. What would be my gain or loss?”

Because you have the account set to reinvest dividends and capital gains, you actually purchased $1,700 worth of shares over the course of last year. So your total basis at the end of the year was $41,700.

So if at the beginning of this year (i.e., before any new money gets invested or distributions get reinvested) you had sold all of the shares for a total of $40,500, then you would have a capital loss of $1,200 (i.e., $40,500 realized on the sale, minus $41,700 cost basis).

If further dividends/capital gains had been reinvested this year before the sale, those would be added to your cost basis as well.

Whether or not you could actually claim this loss would depend on whether or not it’s a wash sale — which it could be, if you own other shares of this same investment (or something else that is “substantially identical”) in another account.

Investing Blog Roundup — Wellness: What Actually Works

My favorite read this week was not directly finance-related at all. Rather, it’s just a brief, research-founded discussion of things that we know work to improve wellbeing in various parts of your life (physical health, mental health, work-life, etc.). As with the best personal finance advice, it’s generally pretty simple stuff.

Other Recommended Reading

Thanks for reading!

Risk Adjusted Returns: What’s the Point?

A reader writes in, asking:

“I don’t understand the point of ‘risk adjusted’ returns. All I’m concerned with is actual returns. If a change to my portfolio ‘improves’ my risk adjusted return but does not improve the actual return, it doesn’t seem like I actually benefit from it.”

I’m sure you would agree that any change to your portfolio that results in an increase to expected return without an increase in risk is an obvious “win.”

Similarly, any change to your portfolio that reduces risk without decreasing expected return is also a “win.” What may not be obvious is that, in such a case, you have the option of happily accepting that lower level of risk, or, if you prefer, you could do something else that brings your risk level back up to what it was before (e.g., shift your stock allocation slightly upward), but now with a higher level of expected return.

In other words, those two things — an increase in expected return without an increase in risk, or a decrease in risk without a decrease in expected return — are somewhat interchangeable. A decrease in risk can easily be exchanged for an increase in expected return.

More broadly, the concept of risk-adjusted return is asking: once we have determined approximately how much risk is acceptable for this portfolio, how can we get the highest expected return for that level of risk?

Everybody Has a Risk Limit

Over the years I have come across several young, risk tolerant investors who have told me that they do not care about risk at all. All they are concerned with is return (or expected return).

That’s nonsense.

Every investor has a limit to the risk they can accept.

Even if your portfolio is 100% stocks right now, you are still forgoing higher-risk, higher-expected return options. For instance, instead of just 100% stocks, why not 100% small-cap value stocks? And why stop at 100%? You could borrow money to invest (i.e., invest on margin). You could short a bond ETF (e.g., have an effective allocation of 110% stocks, -10% bonds). If you haven’t done such things and choose not to do such things, you too have a limit to the risk you will accept.

Sometimes the limit is a financial limit (you cannot afford to take on more risk), and sometimes the limit is a psychological limit (you cannot tolerate more risk). But you definitely have a limit.

Caveats

While the concept of risk-adjusted return is useful for understanding portfolio construction discussions, applying it in real life comes with important caveats.

Firstly, there are many ways to measure risk. Standard deviation of returns is the most popular measure historically. But looking only at the standard deviation of a distribution gives you an incomplete picture. For instance, as Larry Swedroe often mentions, it is helpful to also consider skewness (i.e., how asymmetrical is the distribution of returns) and kurtosis (i.e., how far is the distribution from a normal distribution — how fat are the tails).

And for a retirement stage portfolio (as opposed to an accumulation stage portfolio), we’re concerned with an entirely different set of risk metrics (e.g., probability of portfolio depletion, size of portfolio shortfall, etc.).

Secondly, portfolio changes that clearly achieve either of the goals that we’re discussing here (that is, a reduction in risk without a reduction in expected return or an increase in expected return without an increase in risk) are rare. And you want to have a high degree of skepticism when somebody suggests that they have a way for you to do so, other than simply “diversify” and “reduce costs.”

Investing Blog Roundup: Investors Do Better with All-In-One Funds

Morningstar recently released the annual update to their “Mind the Gap” study, which looks at how well investors do with various categories of mutual funds. That is, it specifically looks at how investors do as compared to the investments — looking to see whether investors make good or bad decisions with the timing of their purchases and sales.

You can find the writeup here. (You’ll need a free Morningstar account to read the article.)

As they have found repeatedly, investors do best with “allocation funds” (i.e., funds that hold a mix of stocks and bonds — balanced funds, target-date funds, etc). Because such funds are not as volatile, people have an easy time simply buying them and holding on to them.

I’ve been saying this for years based on my own experience, and I hear the same thing over and over again from readers.

Other Recommended Reading

Thanks for reading!

Working as an Advisor at Edward Jones: Ethical Qualms

A reader writes in, asking:

“You have mentioned a few times that you were a financial advisor with Edward Jones early in your career. My oldest child will be graduating in May next year, and a local Jones advisor/manager is trying to recruit her to come on board as an advisor after graduation.

I am aware that they still use the old-school commission type of compensation for their advisors, which is often not the best from the client’s point of view. But what I am most interested in knowing is whether you were ever asked to do anything that felt like it was against the client’s interests, or were you generally free to operate as you saw fit, according to your own ethics and best practices.”

A relevant point here is that I worked at Edward Jones for just under a year, and I was 21-22 at the time. So while there is still quite a bit about financial planning that I don’t know, it’s safe to say that I knew much less back then. Point being, there were an assortment of things that they told us to do, which I now realize were less than ideal, but which I just accepted at the time because I didn’t yet know any better.

But, yes, there was one instance that really made me uncomfortable, even with my very limited knowledge.

Immediately after we got our licenses, we were brought back in for a week of sales training at the home office. During that week, two of the days were spent making phone calls to prospective clients whom we had met over the last few months, in order to pitch them an investment product.

We didn’t get to choose the product. On the first day we had to pitch an individual bond. We could choose between a corporate bond (one from General Electric) or an AAA-rated muni bond from the state in which the client lived. I went with the muni bond. I knew it wouldn’t be ideal for plenty of the people I was calling (after all, I had no idea about their tax situation or about the rest of their portfolio), but at least it wasn’t likely to blow up on them.

On the following day, we had to pitch an individual stock. Even back then, I wasn’t at all on board with the idea of selling somebody an individual stock, especially while knowing almost nothing about the person in question. If they put, say, $20,000 into this stock, is that a trivial amount for them? Or are they going to be in a serious predicament if the stock goes south?

In addition, we had a supervisor listening in on the phone call, without the prospect’s knowledge. And we were in a loud room, full of people making similar calls. It was about as far as away from financial planning as you can get.

I remember making a point of calling all my worst prospects (that is, people who I knew were very unlikely to become clients), calling the same numbers repeatedly over the course of the day (i.e., calling people who weren’t home 20 minutes ago, in the hope that that would still not be home now), and intentionally flubbing my sales pitch when I did actually get a hold of somebody.

My plan was to just make it through those two days, then go back to my office in Chicago and run things in a way with which I was more comfortable: constructing diversified mutual fund portfolios. (In fact, this course of action was explicitly recommended to me by the manager in the Chicago region where I was working. Even as a long-term Edward Jones broker — somebody very comfortable with a sales/commission type of advisory role — he thought that the home office’s boiler room-style sales training was terrible for both clients and advisors.)

This was ~13 years ago, so I don’t know in what ways their training process has or hasn’t changed since then. Nonetheless, Edward Jones’ business model is still based on fundamental conflicts of interest between the client and the advisor, and I would not recommend it as a place to work as an advisor (nor as a place to invest as a client).

If at all possible, for a recent graduate interested in working in financial planning, I would instead suggest Michael Kitces’ approach of trying to get a position not as a financial advisor but rather in an operations/support role at a financial advisory firm with a good reputation and client-centric business model. Any place that will hire people as full-fledged advisors right out of undergrad (and with no certifications) is almost certainly going to be employing those people in a product-focused sales role rather than actual financial planning.

Brief tangent: as it happens, the two stocks were Coca Cola and Bank of America. This was in April of 2006. Coca Cola has done great over the period — considerably outperforming the market overall. Bank of America, on the other hand, is down roughly 20% over the entire period, and it had a truly harrowing crash during the 2008-2009 bear market — at one point having declined by more than 90% (!!) from the April 2006 purchase price. Good example of the risk of individual stocks.

Investing Blog Roundup: CFP Directory Not Disclosing Disciplinary Information

There’s been something of a hullabaloo in the last two weeks as a result of a WSJ article about the LetsMakeAPlan website (a directory of financial planners, run by the CFP Board). The WSJ found that the website often does not disclose information about a CFP’s history of discipline by regulatory bodies or history of bankruptcy, even though they have access to such information.

Here’s what the WSJ found:

“The LetsMakeAPlan.org site has been presenting more than 6,300 planners without showing such problems even though the planners have disclosed them to the Financial Industry Regulatory Authority, according to a Wall Street Journal analysis of more than 72,000 profiles on the website.”

Retirement Income Style Awareness Survey

As a separate point of note, retirement researcher Wade Pfau wrote this week about a survey/questionnaire that his firm is working on.

The idea is that it will help people to determine the best personal approach for them to take for retirement income planning.

At this stage they are looking to have about 1,000 people in total take the survey to help determine which questions provide the best explanatory power for helping to define a style in order to make the final version of the survey.

If you’d like to participate, you can find the survey here.

Pfau told me that participants will be able to get results in the Fall once all of the analytics have been worked out. (This is why the survey asks you to create an account — so that you can get your results once everything on the backend has been completed.)

Other Recommended Reading

Thanks for reading!

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