How the “Dogs of the Dow” can make you money while getting you tax-advantaged income.

The “Dogs of the Dow” is an investment strategy that became popular in the early 1990s following a book written by Micheal O’Higgins.  The premise is simple: invest in stocks that are currently disliked or have underperformed (buy low) and wait for the economy, or management, to turn the situation around (sell high).  The problem for investors is determining how to identify the stocks that meet these criteria with the least risk and the possibility of making a profit.

The “Dogs” strategy starts with the 30 stocks in the Dow Jones Industrial Average (the “Dow” ).  To be part of the Dow a company has to have been around for quite a while, be an industry leader, and have stable finances.  Investing in these stocks means that the risk of investing in a real “loser” are low.

So which of these 30 stocks are under-loved?  The “Dogs” use dividend yield as a proxy for being underappreciated and undervalued.  At any one time, the “Dogs” are the top 10 highest yielding stocks in the Dow.

The final step is to invest an equal number of dollars in each of these ten stocks, hold them for a year, and repeat the process.  This usually means that after a year some of the stocks you own will no longer be among the top ten dividend payers, and each stock will no longer be one-tenth of your Dogs portfolio.  You sell those who are no longer in the top ten, replacing them with stocks that have become one of the top ten dividend payers, and re-balance the Dogs back to equal dollar amounts.

The “Dogs of the  Dow” strategy has been promoted as a way of beating the Dow, and in some years it has.  But that’s not necessarily the reason it may be appropriate for some investors, especially those who are looking for tax advantaged income.

Let’s look at the tax code.  The maximum rate of tax on qualified dividends is:

  • 0% on any amount that otherwise would be taxed at a 10% or 15% rate.
  • 15% on any amount that otherwise would be taxed at rates greater than 15% but less than 39.6%.
  • 20% on any amount that otherwise would be taxed at a 39.6% rate.

In other words, “qualified” dividends (dividends paid by a U.S. corporation or a qualified foreign corporation)  are taxed like long-term capital gains, and at a lower rate than interest on CDs, corporate bonds and treasury bonds. At a time of ultra-low interest rates, getting a dividend of 3% to over 5% from a Blue Chip company may offer an attractive alternative to investing in bonds for those looking for current income.

In addition, of you sell a stock after holding it for a year and make a profit that is considered a long-term capital gain.  And long-term capital gains are also taxed at preferential rates.

There are some other requirements that affect the tax rate on qualified dividends and capital gains so consult your tax advisor about your particular situation.

The Dogs are not for everyone.  First, ten stocks are not considered a well-diversified portfolio and we at Korving & Company believe firmly in diversification.  Second, at some point the stock market will take another tumble and the Dogs will tumble along with the rest and we are also big practitioners of risk control.  Third, unlike CDs and high quality bonds, stocks never “mature” and pay you back your principal.  Investing in stocks exposes you to more risk that putting your money in the bank or purchasing short-term treasury bonds.  Before recommending that people invest in the Dogs, we carefully examine whether this is right for them.   Don’t buy the Dogs without getting professional advice.

However, at a time when many are anticipating that interest rates will go up, which means that bond prices will go down, people looking for income may want to consider if the Dogs are right for them.

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