Common dividend investing mistakes

Mistake 1: Chasing the highest yield

Yield rises when the price falls. A hypothetical stock paying $2.25 a year yields 4.5% at $50. If the price drops to $25 because investors expect trouble, the same dividend yields 9.0%. Nothing about the company became more generous; the market became more worried. If the dividend is then halved, the yield on $25 drops back to 4.5%, and the holder has also lost half the share value.

A high yield is a reason to ask questions, not an answer. Comparing a stock’s yield with its own history, and with similar companies, often says more than the raw number. See yield traps and the yield trap checker.

Mistake 2: Ignoring the payout ratio and debt

A dividend is paid from cash. If a company pays out more than it earns, or borrows to keep paying, the dividend depends on conditions continuing to cooperate. As a rough rule of thumb, payout ratios above about 80% of earnings leave a thin cushion, but normal levels vary a lot by industry, and some sectors, such as real estate trusts, are usually judged on cash-flow measures instead.

For example, a hypothetical company earning $2.00 a share and paying $1.80 has a 90% payout ratio. If earnings fall 20% to $1.60, the dividend is no longer covered by earnings, and something has to give: the dividend, the cash balance or the debt load.

Debt matters because lenders are paid before shareholders. Rising interest costs can squeeze the cash available for dividends even when earnings look steady. The payout ratio and free cash flow are most useful read together.

Mistake 3: Concentrating income in one sector

Dividend payers can cluster in a few industries. A portfolio can hold fifteen companies and still get most of its income from one sector that responds to the same pressures, such as interest rates or regulation. Where the income comes from matters more than how many holdings there are.

Mistake 4: Holding dividends in the wrong account

For Canadian residents, US dividends are generally subject to 15% US withholding under the Canada–US tax treaty (versus 30% without treaty documentation, usually a W-8BEN). In an RRSP or RRIF, the treaty exempts them from US withholding. In a TFSA, RESP or FHSA, the 15% is withheld and can’t be recovered. In a non-registered account, it may be claimed as a foreign tax credit, but US dividends there don’t get the Canadian dividend tax credit; they’re taxed like interest.

On $1,000 of US dividends, that’s the difference between $1,000 arriving in an RRSP and $850 in a TFSA. The US withholding tax calculator runs your own figures.

US investors face different questions: whether dividends are qualified, the holding period and, at higher incomes, the 3.8% net investment income tax.

Mistake 5: Forgetting reinvested dividends in your cost base

In a Canadian non-registered account, dividends reinvested through a DRIP are taxable in the year paid even though no cash reaches you, and each reinvestment adds to your adjusted cost base (ACB). Forget to add them and you overstate your gain when you sell, paying tax twice on the same money. In the US, reinvested dividends are still taxable dividends too, so good records matter on both sides of the border.

Mistakes 6 and 7: Annualizing specials and misreading yield on cost

A one-time special dividend counted as if it repeats can make a 4% yield look like 12% or more. For example, a $0.25 quarterly dividend plus a one-time $2.00 special on a $25 share is a 12.0% trailing yield, but only 4.0% from regular payments. Only regular payments belong in an estimate of ongoing income; see special dividends.

Yield on cost compares today’s dividend with what you paid years ago. A holding with a 6% yield on cost may be producing only 3% on what the shares are worth today, and that current figure is the one that reflects the money you have tied up. See yield on cost explained.

A quick self-check