Taxes Don't Wag the Dividend Dog

11/08/2010 1:00 pm EST

Focus: MARKETS

Kelley Wright

Managing Editor, Investment Quality Trends

Kelley Wright, managing editor of Investment Quality Trends, says investors shouldn’t be distracted by elections or taxes, but should focus on quality, dividend-paying stocks.

What real effect, if any, will [the results of the midterm elections]  have on the economy and the markets? What real effect, if any, will this have on you and me as investors?

The honest answer is that nobody really knows. To be sure there are some who believe there will be ABC policy changes that will produce XYZ results. This may become a fact or prove to merely be opinion, which are two entirely different things.

There will be no panaceas coming from Washington, DC. There might, however, be some curveballs—specifically, one that pertains to tax policy.

By example, will investors sell dividend-paying stocks if they believe the income tax rate applied to dividends will increase? If investor psychology remains true to form, expect a majority of investors to have a knee-jerk reaction to what most surely will be perceived as a giant negative event. Forget the fact that the majority of equities are held in tax-deferred accounts and that before 2003, stock dividends were always taxed at ordinary income tax rates and yet, dividend-paying stocks still outperformed non-dividend-paying stocks.

Conversely, what if the current income tax rate for qualified dividends remains in place? Will there be an equally strong knee-jerk that results in an increase in prices for dividend-paying stocks?

While taxes do have an impact on returns, so do trading costs and management fees. These impacts pale in significance, however, to the long-term impact on performance that the companies you choose to invest in does. If you opt for speculative companies instead of investing in quality companies that represent good values, who cares what the income tax rates on dividends are?

I have never been a believer in letting the tax tail wag the investment dog. The fact is that investors have a silent partner named Uncle Sam. His hand will be in your pocket, to varying degrees, depending on what the tax code allows at any given time. Unfortunately, this is never going to change. This is not to say that some government policies don’t negatively affect the markets and the economy.

Between unemployment, a shaky recovery, the Federal Reserve apparently behind the proverbial eight-ball, and yes, the election, there are a lot of distractions for investors to deal with. The fact is though, there are always distractions. Our job is to remain focused on what we control: when and what we invest in.

Even though our basket of undervalued stocks is dwindling and value is becoming scarcer, there are still opportunities to add quality and value to your portfolio. [So,] be patient, collect your dividends, and know that this, too, shall pass, as there will be another bull market; there always is.

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