Dividends from Canadian stocks are the current darling of our investment world. However, there are other ways that may be better for generating income from your portfolio.
The reason for the rush to Canadian paying dividends is the dividend tax credit that reduces taxes paid from these dividends. Another way to produce revenue from owning stocks or mutual funds that own stocks is to sell some of the investments.
If there is a capital gain then the favorable tax treatment on that source of revenue can be about as good as receiving Canadian dividends. For investments inside non-registered plans, only half of any capital gain is taxable.
If there is no capital gain on the investment you sell, then there is no income tax paid. You sell one dollar and keep the whole dollar without paying any taxes.
The problem for most people is the notion that you are better served if you can just spend your income and do not touch the capital. This sounds like a good idea except dividends are just another form of selling investments.
There is nothing sacred about dividends. When a company distributes dividends to shareholders they are effectively selling some of that company in the form of paying out cash.
For simplicity let us assume your investment in a company was worth one dollar. That company pays you a dividend of five cents so now the value of your share is reduced to ninety-five cents.
Compare that investment to a similar company that did not pay a dividend. Your investment is worth one dollar and if you sold five cents your investment would be reduced to ninety-five cents.
This is the same logic. In one case a company paid a dividend and in the other case you created your own form of dividend by just selling a small number of shares. In the end you are left with a ninety-five cent investment.
When you sell stocks or units of a mutual fund owning stocks, the money received will largely be a return of capital which is not taxable.
A Canadian dividend is just another form of return on capital except all of the dividend must be included for tax purposes. Dividends do not come from earnings they come from cash held by the company.
Do not get dividends confused with the underlying value of a company. Dividends are paid from cash the company has and is not dependent upon profits.
Many of the most successful companies do not pay dividends. The value of all companies is determined by the market and is based on the market estimates of future cash flow of the company.
Nobel laureates Merton Miller and Franco Modigliani said “values are determined solely ….by the earning power of a firm’s assets….and not how the fruits of the earning power are packaged for distribution.”
When investors concentrate on Canadian stocks that pay dividends they are committing a cardinal sin. Their portfolio lacks diversification, and therefore is more risky. The irony is that the type of investor looking for dividend paying stocks is often more conservative compared to an investor who just wants capital appreciation.
Canada represents four per cent of the world capital markets. Diversification in other parts of the world is the starting point in any well-constructed portfolio to manage investment risk.
We recommend creating the safest and best investment portfolio needed to satisfy your financial objectives. Once that is done, then determine the best way to go about generating the desired income you need.
Constructing an overweighed Canadian stock dividend paying portfolio is like the tail wagging the dog. Start with the sound fundamentals of diversification and the better your portfolio the better the chance that it will meet your income needs.