What is dividend stripping? | Definitions for investing | Pearler (2024)

Dividend stripping is a term you might hear in investment circles. It’s a practice that could pique your curiosity as an investor, especially in conversations with other investors who promote it. But there’s always another side to the story. And that’s the purpose of this article – to fill you in on the other side of dividend stripping. In this piece, we'll aim to help you understand dividend stripping as an investing strategy and why it’s seen as an unfavourable practice among long-term investors.

We’ll also look at how dividend stripping works and its consequences, and compare it to the long-term investing approach. Understanding these differences can help you make wise investment choices and move forward on your investing journey.

Dividend stripping – how it works

Dividend stripping is a short-term trading strategy used by some investors. It involves an investor buying shares just before a company pays dividends. After receiving the dividends, they sell the shares. The goal is to profit from the dividend payment.

Here's how it works:

1. An investor buys shares of a company.
2. The company makes a dividend announcement .
3. The investor holds the shares until the dividend is paid.
4. The investor sells the shares after the dividend payment.

Investors engage in dividend stripping for a few reasons:

• Immediate cash flow : Receiving dividends provides instant income. This can be appealing, especially for those seeking quick returns. However, share prices often drop after dividends are paid and can offset the gains from the dividend.
• Tax benefits : In some cases, investors aim to exploit tax rules. They might use dividend stripping to reduce their tax liabilities. However, this approach can lead to scrutiny (and potentially consequences) from tax authorities.
• Market timing : Some investors believe they can predict short-term price movements. They hope to buy low, collect the dividend, and sell high. This strategy relies on precise timing, which is difficult to achieve.
• Speculative gains : Dividend stripping is often seen as a higher risk, higher reward approach. Investors with a higher risk tolerance might pursue it for potential short-term gains.

While these reasons can be tempting, the risks and potential downsides often outweigh the benefits. Understanding these motivations helps to highlight why the Pearler community generally favours a long-term investing approach.

Consequences of dividend stripping – an example

Let's consider a fictional investor named John. John decides to engage in dividend stripping. He buys 1,000 shares of XYZ Corporation a few days before the company announces its dividend.

John is attracted to the immediate cash flow from dividends. He believes he can make a quick profit by selling the shares right after the dividend payment. He also thinks he can exploit a loophole in the tax system to reduce his tax liability.

The process

1. John buys 1,000 shares of XYZ Corporation at $10 per share. His total investment is $10,000.
2. XYZ Corporation announces a dividend of $1 per share.
3. John receives a total dividend payment of $1,000.
4. The day after the dividend is paid, the share price of XYZ Corporation drops to $9.

The consequences

John decides to sell his shares at the new price of $9 each. Here's what happens:

• Sale proceeds: 1,000 shares x $9 = $9,000.
• Total dividend received: $1,000.
• Total proceeds: $9,000 (sale) + $1,000 (dividend) = $10,000.
• Original investment/base cost: $10,000.

At first glance, it looks like John breaks even. However, he has to pay a dividend tax. Assuming his marginal tax rate is 32.5%, John pays $325 in taxes on the $1,000 dividend.

So, John's net proceeds are $10,000 - $325 = $9,675.

In the end, John loses $325, considering he initially invested $10,000. He also may be further taxed when he sells his shares if the price went up in value when selling, ituation as . This hypothetical example shows how dividend stripping can lead to financial loss. John's attempt to make a quick profit backfires due to the drop in share price and tax obligations.

This example illustrates the risks and pitfalls of dividend stripping. It also highlights why this strategy is often not worth the potential gains.

Real-world consequences of dividend stripping

The previous example might be hypothetical, but there are also real-world consequences of dividend stripping. In fact, the investing strategy has a history of controversy. For context, here are two key examples.

Case Study 1: Australia in the 1980s

In the 1980s, many Australian investors engaged in dividend stripping. They sought to exploit the dividend imputation system designed to avoid double taxation of dividends at the time. However, it led to a spike in dividend stripping activities as investors sought dividend tax avoidance .

The Australian Taxation Office (ATO) noticed this trend and saw it as an abuse of tax rules. In response, the ATO introduced stricter regulations, including anti-dividend stripping rules. These changes reduced the attractiveness of dividend stripping as investors faced audits and penalties.

Case Study 2: United States in the 2000s

A similar trend occurred in the United States during the early 2000s. Investors took advantage of short-term price movements around dividend dates. They aimed to profit from dividends while minimising tax liabilities.

The Internal Revenue Service (IRS) responded by tightening tax rules and introducing measures to prevent such practices. Many investors who engaged in dividend stripping faced significant financial losses. The stricter regulations discouraged the practice.

These historical examples show the risks of dividend stripping. Investors who have engaged in this strategy often face negative consequences.

Comparing dividend stripping to long-term investing

As mentioned, at Pearler, our values are aligned with the long-term investing approach. Dividend stripping is a very different investing strategy. It focuses on short-term gains, while long-term investing aims for steady growth over time. Let’s look at how the two strategies compare:

Long-term investing leans toward being a more gradual approach to growing wealth. Here’s why we support the long-term investing approach:

• Steady growth : Long-term investments can potentially benefit from compounding returns. Reinvesting earnings often generates more returns over time.
• Lower risk : Holding investments for the long term helps ride out market volatility. This can reduce the impact of short-term market changes.
• Simplicity : Requires less frequent trading and monitoring. This tends to make portfolio management easier and less stressful.
• Alignment with goals : Long-term investing aligns with goals like retirement savings, education funding, and wealth preservation. It supports more sustainable growth and the pursuit of financial independence.

Though dividend stripping might seem attractive for quick gains, it’s also risky and complicated. Long-term investing, meanwhile, can potentially provide a more stable and reliable path to building wealth. By focusing on sensible growth strategies, you can achieve your financial goals with greater peace of mind.

Remember, all investments carry some risk, including those aligned with long-term investing principles. Consider the risk involved before investing and if you’re unsure about what’s right for you, seeking professional advice may be helpful.

Find the right strategy for you

Dividend stripping may seem like a quick way to earn money, but it comes with significant risks. Historical examples show that it often leads to short-term capital loss, tax complications, and regulatory scrutiny.

In contrast, long-term investing can generally offer a more stable path to building wealth. It focuses on steady growth, lower risk, and tax efficiency.

Choosing an investment strategy depends on your individual goals and risk tolerance. Understanding the pros and cons of different approaches can help you make informed investment decisions. Consider what aligns best with your financial objectives and comfort with risk.

Happy investing!