Should I Sell a Dividend Stock to Take Profits?
Contributed by Dave Van Knapp
Most dividend investors do not trade much. We often subscribe to this philosophy:
Most dividend investors do not trade much. We often subscribe to this philosophy:
When you buy a stock, your hoped-for holding period is forever.
– Warren Buffett
That’s why selling decisions are more difficult than buying decisions. Here is one decision that can be particularly vexing:
- Should you sell a dividend stock if its price goes way up, to lock in the big gain?
Dividend investors know that if they sell or trim a stock to lock in profits, they will own fewer shares and collect less dividends from that stock.
They may not think that it is wise to interrupt dividend compounding by selling shares to take profits.
What Circumstances Trigger the Selling Quandary?
Before we get into details about whether to sell or not, let’s be clear about how the question comes up.
1. You invest in stocks with a primary focus on their dividends. Your main goal is to build a growing dividend stream, over the long haul, for retirement.
1. You invest in stocks with a primary focus on their dividends. Your main goal is to build a growing dividend stream, over the long haul, for retirement.
2. You own a fine dividend stock that has been delivering what you expected. The dividend has been increased every year at a good rate. You have no reason to doubt that this will continue.
3. But the stock, quite unexpectedly, catches fire. Its price goes way up – say by 30%, 50%, or even hundreds of percent. When you do the math, you see that your unrealized profits exceed the stock’s probable dividend payouts for the next decade or longer.
4. But the profits are only on paper. They might disappear quickly if the market suddenly turns in the other direction.
5. The stock’s dividend yield has dropped to an insignificant level. Yields move inversely to price, so the stock has morphed from being a “dividend” stock into a “growth” stock that happens to pay a small dividend.
So the question becomes: As a dividend investor, how do you know when you should sell a stock to lock in a big gain? (For a broader article about selling in general, please see this article: When Should I Sell My Stocks?)
How Selling May Fit Your Business Model
In your stock investing, what is your primary measure of success?
The illustration below is the investment model for many dividend investors.
Their investing is designed to build a reliable, growing, and predictable income stream from dividend stocks. It is not based on flipping stocks for profit.
Focus on the step circled in orange: Manage. What does that mean?
Portfolio management means to take actions, in an existing portfolio, that improve the output of the whole business model.
Some things that dividend investors do to optimize their income stream are:
- Make sure it is safe. At Simply Safe Dividends, our Dividend Safety Scores™ speak directly to that need.
- Ensure that the income stream grows every year. When growth falters, take actions to correct the problem area.
- Reinvest the dividends to buy more shares. Those new shares produce more dividends, which help grow the portfolio’s income stream, because dividends are paid per share.
- Sell, trim, and adjust position sizes to optimize the portfolio’s overall performance.
It is that last bullet point that leads us to consider whether to sell a stock to realize capital gains: Can we enhance the portfolio’s overall performance by selling or trimming a stock that has ballooned in price?
Reasons to Sell
I am going to use Microsoft (MSFT) as an example of how potential reasons to sell or trim a stock arise when a dividend stock’s price goes sky-high.
Here is Microsoft’s story:
- In August, 2015, MSFT’s yield touched 3.1%, the highest it has ever been.
- As I write this in June, 2023, MSFT’s yield has dropped to 0.83%, even though its annual dividend payout has doubled since 2015.
- The reason the current yield has dropped so much is that Microsoft’s price has risen 678% since that high-yield point.
I have owned Microsoft since 2014. I have zero concerns about its dividend performance. Indeed, it has been excellent, and I expect that to continue.
But Microsoft's giant price increase over the past eight years has simply overwhelmed its dividend performance. Nobody buys Microsoft as a “dividend stock” these days.
In a situation like that, reasons develop that may point to selling or trimming a position.
Reasons to Sell #1: The stock may have become too big for your portfolio.
As investors, we have all heard about diversification: Don’t put all your eggs in one basket, because that is too risky.
Someone holding a stock like Microsoft over the past few years might find that its position size in their portfolio has become uncomfortably large. For example, instead of comprising (say) 5% of their portfolio, it may have grown to 10%, 20%, or more of their total investments.
That may be too much risk in one stock, even given the undeniable quality of Microsoft as a company. You may want to trim it in order to bring its size back to something more normal for your portfolio.
Reasons to Sell #2: The stock may have become seriously overvalued.
When a stock has a huge price gain, its valuation may have gone far beyond what the stock is actually worth. When that happens, the stock may have lost any margin of safety that it once had.
Here are some clues about Microsoft’s valuation from our coverage of Microsoft’s Timeliness. (For more detail about Timeliness, see this article.)
Look at each of the four data points:
- Dividend Yield: The graph tells us that Microsoft is yielding just 0.83%, which is below both its 5-year average yield and its top yield looking back five years.
- Forward P/E Ratio: Microsoft’s current Price/Earnings ratio of 31.2 is well above its 5-year average of 28.1.
- Sector P/E Ratio Comparison: Microsoft’s P/E of 31.2 is 50% above the Information Technology sector’s 20.7.
- 52-Week Price Range: Microsoft’s current price is the highest that it has been in the last year.
All four of these data points imply that Microsoft could be overvalued.
While overvaluation, by itself, might not be a convincing reason to sell all your shares in a great company like Microsoft, it may nudge you to consider trimming in order to lock in some of those profits.
Reasons to Sell #3: You have an opportunity to collect several years’ worth of dividends instantly by trimming the position.
If you own $10,000 in Microsoft shares, you are collecting $83 per year in dividends from them.
If you trimmed just $1000 in shares, that sale would net you about 12 years’ worth of dividends immediately.
If you trimmed just $1000 in shares, that sale would net you about 12 years’ worth of dividends immediately.
Reasons to Sell #4: The stock’s yield may have dropped below a worthwhile amount.
At 0.83%, Microsoft’s current yield may be below what many dividend investors have set as their floor. Combined with other reasons, the low yield may influence a trim.
Reasons to Sell #5: At the stock’s new lower yield after a price run-up, its dividend growth rate may no longer be sufficient.
It’s one thing to have a 7%-yielding stock offer little annual dividend growth. That is perfectly acceptable to many dividend investors.
It is common for investors to consider yield and growth rate in tandem. One common technique is to add the yield to the 5-year dividend growth rate (DGR) and set a minimum for the combined number.
A common minimum target is 10%. Microsoft just barely passes this test, but a stock with a 2% yield and 5% DGR would not.
Reasons to Sell #6: You can probably redeploy your profits to enhance both dividend amount and growth.
If you decide to trim an overpriced, low-yield stock, you can invest the money into another high-quality stock that is not overvalued and that sports a much higher yield.
Using the Microsoft example, you could take $1,000 in proceeds and invest it in a high-quality stock that is yielding, say, 4%. Your annual income generated by that money would grow from $8.30 to $40 immediately.
How Much to Sell
Let’s say that you do decide to trim – that is, sell part of – an inflated position to lock in some profits. How much of the position should you sell?
I hate to say, “it depends,” but that is the answer. The fact is, there is no single best answer for everyone or every situation. You want to find an answer that advances your own goals.
An income-centric investor may put the most weight on the maximum dividend dollars she can obtain from her portfolio. She might end up selling most or all of her MSFT shares in order to convert the profits into more income from a different stock. You can see our favorite high-yield stocks here.
But a growth-and-income investor, with hybrid goals, might want to trim less (or none at all), reasoning that not only is Microsoft providing the income he originally expected, but also that MSFT offers more opportunity for further growth than any alternative “dividend stock” out there.
To cover a wide range of investors, here are several approaches that I have seen advocated.
(1) If you have a maximum-position-size guideline, follow that.
Here is a simple example from my own experience: I had a stock that exceeded my max-size ceiling, which is 6% of the portfolio. I trimmed it back to 5% size. That left room for it to continue to grow without hitting the ceiling again for a while. I moved the money to build up a smaller position offering a higher yield. My income went up right away.
(2) Sell enough to take the position size back to how much you originally invested.
Say you originally invested $5,000, and the position has grown to $8,000. Sell $3,000 of the position, all of which is profit. That brings the amount invested back to its original size while freeing up the profit to invest elsewhere.
(3) Sell enough to capture 10 years’ worth of dividends.
Ignoring for a moment that dividends will grow on their own, a simple example would be that if the stock pays a 4% dividend, then 10 years of dividends on $10,000 of the stock would be $4,000. Sell that much.
Again, this hybrid approach realizes some gains for investment elsewhere while retaining exposure to the stock’s future growth potential.
(4) Sell half and keep half.
Once again, this “have your cake and eat it too” approach retains some of the potential for future capital gains from the stock, but it locks in a portion of the capital gains already available.
How Trimming Can Increase Your Dividends
Trimming an appreciated stock can increase your portfolio’s dividends if you reinvest the sale proceeds into a stock with a higher yield.
Sticking with the Microsoft example, let’s say you have found a stock (maybe one that you already own) with a very safe dividend, strong business, and stellar record of dividend growth. It is yielding 4% and selling at an attractive price.
You decide to trim $5,000 of your Microsoft position to lock in several years’ worth of profits, and to transfer the money to the other stock.
Upon completion of the trim and replacement, your dividend income generated by the same money will go from $41.50 to $200 per year.
Here is the before-and-after look at how selling to lock in capital gains can promote the overall goals of an income-centric investor.
Tax Considerations
If your portfolio is in a tax-deferred account, such as a traditional IRA, selling to lock in profits is not a taxable event. Taxes are deferred until you withdraw money from the IRA.
If your portfolio is in a Roth IRA, there are no tax considerations at all. The money to set up the Roth was already taxed, and transactions within the Roth carry no further tax consequences.
If your portfolio is in a taxable account, taxes will probably be due on the profits that you take. You can pay those taxes from the profits or from another source.
Conclusion
Ultimately, the decision to sell a dividend stock and realize capital gains should be based on a thoughtful analysis of your investment goals and risk tolerance.
I suggest that you run a few simple scenarios and attempt to look out two to three years:
- In one scenario, you sit tight and do nothing. Where is your portfolio likely to be in a couple of years?
- In a few other scenarios, do the simple math of pretending to sell X% or $Y shares in the inflated stock, and reinvest the proceeds into a different stock that has high quality, good valuation, and a better yield.
- In making your projections, consider not only what things would look like if the inflated stock continues to rise in price, but also what you would have if the stock turns around and gives up much of its gains.
I think that after running a handful of scenarios, you will have an answer that you are comfortable with.
Thanks for reading!
