Everyone assumes some of the Wall Street experts know everything there is to know about the stock market, however, sometimes the information you hear from them is not accurate. Here is a list of the five gotcha’s that Wall Street tries to hide from you.
1) You Cannot Get Market Returns Yourself
The first gotcha that Wall Street tries to hide from you is that you cannot get market returns yourself, and because you cannot get market returns yourself, you should hand over your money to a “professional” so that those “professionals” can get those returns for you.
This is not true at all. Anyone with a laptop and an online brokerage account can get market returns over the course of the year by buying certain products which were created to mimic returns of the overall market or index.
For example, most professional traders and money managers compare their results to the S&P 500 Index. This is an index comprised of 500 stocks in different sectors such as consumer discretionary, energy, and health care. The S&P being comprised of 500 stocks also gives a large enough sample size for a snapshot of the overall market.
Getting the same returns as the S&P 500 is actually quite simple. In 1993, State Street Advisors created the first ETF known as the S&P 500 Index ETF with the symbol of $SPY. The goal of this ETF was to mimic market returns by having the same exact holdings as the S&P 500 Index itself. With that said, buying the S&P 500 Index ETF will get you market returns every single time!
2) All Dividends Are Created Equal
Everyone loves dividends, right? If you own a dividend stock, you qualify for a dividend payment which most of the time gets paid out once a quarter by the company whose stock you own if they pay a dividend to shareholders.
Besides getting paid to own the stock, many investors like dividend stocks because they are taxed at a lower rate when compared to ordinary income. Taxes on dividends range from anywhere between 0 and 23.8% (capital gains rates), which are typically less than ordinary income.
Dividends make sense. Own a stock that you think will go higher, get paid to do so, and be taxed at a lower rate. Awesome, right?
Unfortunately, not all dividends qualify for these low tax rates. Non-qualified dividends come when a company pays out large amounts of their yearly profits in the form of dividends. For example, REITs pay out up to 90% of their profits as dividends but those dividends are non-qualified, so the dividend recipients of REITs do not get their dividends taxed at capital gains rates, rather, those dividends are taxed as ordinary income.
3) Dividends Prove A Company Is Strong
Wall Street likes to tell people that if a company is strong they will have enough money to pay a dividend. So if a company pays a dividend, it is assumed the company is strong.
There are a few reasons why this is not the case.
First, companies can borrow money and go further into debt just to pay dividends. With interest rates as low as they are now, companies can borrow money at lower interest rates than their current dividend yield. That does not make a company strong, it only proves the point that interest rates are low.
Second, what do Facebook, Amazon, Netflix, and Google (FANG stocks) all have in common? They are all growth companies! But what else do they have in common? They all do not pay a dividend. The reality is, a lot of companies feel it is a better proposition to reinvest profits back into the company to grow the business. A lot of the time, when companies do not feel reinvesting profits is a good strategy, they will just pay people to hold their stock in the form of a dividend.
I don’t know about you, but I want to own shares of companies who are reinvesting their profits because they think that is worth it.
4) You Have To Hold Stocks For A Year To Receive Capital Gains
Most of the time, capital gains are created when a stock is held for one full year. Wall Street will tell you this is the only way to receive capital gains.
Unfortunately, this is not true. According to IRS Section 1256 Marked to Market, there are significant tax advantage to trading options in broad based indexes (such as the S&P 500 Index) or future options (such as the E-mini S&P 500 Futures contracts). 60% of all gains in those products (regardless of the length of time in the trade) can be taxed at the capital gains rate while 40% of gains in those products have to be taxed as ordinary income.
This tax advantage for broad based index options and futures options is a large advantage to investors and traders with larger accounts as these products require substantial capital to participate in trading/investing in them. However, 60% of the gains made in a broad based equity index trade that lasted for all of five minutes are able to be taxed at capital gains rates.
5) It Is A Stock Picker’s Game
If you turn on the television and tune into the likes of a CNBC or Bloomberg, you will undoubtedly find the one screen commentators speaking about individual stocks; stocks that have huge potential to go up, down side, or be acquired by another company.
This focus on individual companies creates the belief that individual investors should go out there, focus on individual stocks, and look for diamonds in the rough such as the next Amazon or Apple.
The top money managers in the world do own individual stocks and bonds, however, the majority of their holdings are in index products; those products which give a diversified approach to investing by spreading our across multiple sectors and asset class.
Rather than picking stocks, I recommend choosing index products or ETFs.
Wrapping Up
To summarize what we have spoken about, here are the five gotcha’s that Wall Street tries to hide from you:
- You Cannot Get Market Returns Yourself
- All Dividends Are Created Equal
- Dividends Prove A Company Is Strong
- You Have To Hold Stocks For A Year To Receive Capital Gains
- It Is A Stock Picker’s Game
Anyone have any other gotcha’s to add to this list?
James Hendrickson is an internet entrepreneur, blogging junky, hunter and personal finance geek. When he’s not lurking in coffee shops in Portland, Oregon, you’ll find him in the Pacific Northwest’s great outdoors. James has a masters degree in Sociology from the University of Maryland at College Park and a Bachelors degree on Sociology from Earlham College. He loves individual stocks, bonds and precious metals.
