How to Implement a Dow Dividend Strategy

There are two basic ways to execute a Dow Dividend Strategy: 1) Buy a Unit Investment Trust from a broker, or 2) Trade for Yourself in brokerage account. Some of the pros and cons of each approach are:

Unit Investment Trust (UIT): These are pools of securities (stocks in the Dow Jones Industrial Average in this case) that in effect collect money from individuals, buy the stocks in the strategy, and after a period of time, sell the stocks and distribute the proceeds to the individual investors. Such pools are passively managed in that no adjustments are made to the portfolio after the stocks have been purchased. Typically, the UITs using a Dow Dividend strategy buy the ten highest yielding Dow stocks at the end of a month and hold them for one year. If you are interested in a UIT, you will probably have to contact a "full service" broker such as Merrill Lynch or Dean Witter. It is also possible that discount brokers that offer more than the basic services, such as Schwab or Fidelity, may also sell UITs. However, the costs are probably the same no matter which broker you use. (These names are provided for illustrative purposes and should not be considered as a recommendation to use a particular brokerage firm.) You pay an up-front fee when you buy a UIT, which is typically 2 to 3% of the amount invested.

Advantages of UITs include:

• Convenience: You write one check and you are done. The manager of the trust figures out which stocks to buy, buys them and later sells them. Also, the trust collects the dividends and sends you a check every month or quarter.
• Small Investment: The minimum investment may be as low as $1,000 (or $250 for IRAs). For small investors, the costs of buying a UIT may be less than the commissions that would be paid to buy and sell the stocks in an individual brokerage account.

Disadvantages of UITs include:

• Limited Choices: You may not be able to find a UIT that does anything other than buy the ten highest yields (High10 strategy). If there is another type (you may need to check with several brokers), it is likely to be buying the five lowest priced of the ten highest yielders (BTD5). As the results shown elsewhere on this site demonstrate, there are more attractive Dow Dividend strategies.
• High Costs: If you have an amount to invest that is somewhat above the UIT minimum, you probably can buy and sell the stocks yourself, paying commissions, at lower cost than the UIT fee. There are now "deep deep discount" brokers that will execute simple orders to buy or sell for $20 or less. Generally, you have to place the orders without talking to a broker by using an automated phone system or your computer, possibly via the Internet. Inexperienced investors may want to place the first few orders by talking to a person, which most of these firms permit for an additional fee. There are also a range of deep discount brokers that allow voice placement of orders and charge $30 to $50 per transaction. Discount brokers do not provide investment advice (some do have research materials they can send you), but since you will have done all the work necessary to figure out which stocks to buy and sell as part of a Dow Dividend strategy, you won't need any advice.

Trade for Yourself: Obviously, you will need a brokerage account to place your trades. Experienced investors who do their own research and make their own decisions are best off using brokers who charge the lowest commissions. There are numerous advertisements in financial publications and on CNBC that can be used to generate a list for additional inquiries. The Internet is also a source of leads for brokers. An investor who has never had a brokerage account and wants to get started with a Dow Dividend strategy may want a broker with a local office that can provide guidance in filling out the forms and a personal broker to answer questions. Several discount brokers, such as Waterhouse, Schwab, and Fidelity, have offices in the larger metropolitan areas. These firms and others also have a wide selection of mutual funds that can be bought and sold with no transaction fees should the investor wish to diversify in this manner. The advantages and disadvantages of UITs discussed above are respectively disadvantages and advantages of doing your own trading.

Additional potential advantages of trading for yourself include:

• Tax Advantages: If you follow my recommendation and execute your strategy by trading around the beginning of the year, you can time the sales for a tax advantage. Usually, but not always, this means selling losers in the current year and deferring the sale of winners until the following year. It may be possible to generate short-term capital losses in one year and long-term capital gains in the next year, which are the most tax-favored outcomes.
• Holdover Stocks: It is common for some of the stocks purchased according to a Dow Dividend strategy to be part of the strategy in the following year. A UIT, in effect, sells all stock at the end of its holding period and then repurchases some of them if the investor rolls over into another UIT. In your own brokerage account, you can just hold onto the holdover stocks. If you do not "rebalance," then there is a commission savings. Moreover, if you have a gain in a holdover stock, by not selling it, you do not realize the gain and generate a tax liability.
• Margin: If you are aggressive, you can open a margin account with your broker (but not in a retirement account), which enables you to buy stock with a value of up to twice the amount of money you put into the account. Buying on margin increases leverage and profits if the portfolio increases in value, but at additional cost and risks. The amount of stock not paid for is a loan from the broker on which interest is paid. If the value of the portfolio drops by too much, the broker will require you to add money or securities to your account (a "margin call") or will sell some or all of your holdings, with or without your consent. Being forced to sell can negate the benefits of a Dow Dividend strategy and could turn a potential winning year into a losing one.

There is at least one potential additional disadvantage to doing your own trading:

• Discipline: Executing a strategy that is based on formulas, like the Dow Dividend strategies, requires the discipline to stick with your plan and not abandon it during the year because "it doesn't feel right," or "I am scared about what the market is going to do," or some other emotional reason. With a UIT, you are "stuck" with the strategy until its holding period is up, but you can place an order to sell in your own brokerage account any day the market is open. If you decide to follow a version of the Dow Dividend strategy, you should stick with it for at least a year, and probably for several years before deciding that it is not right for you. There is a real temptation to try to "time the market" by selling when you think the market or some of your stocks are about to fall. You will believe that this indeed will happen and you will be able to buy back at lower prices. This is very difficult to do consistently, and most investors will decrease their returns by trying. One of the beauties of these strategies is that they don't require intervention or judgment about what the market will do. Over time, they work, so just stick to them. The temptation to trade the stocks during the year will be even greater if you have an account with a "full service" broker whose account representatives provide investment advice. These reps make their money from commissions and have an incentive for you to trade frequently. Normally, they will call you every so often with another idea or some reason why you should sell some of the stock you already own. ("It is up 20% already, which is very good, and you won't go broke by taking profits. Our research department shows that it is now 'fully valued' so you should switch to XYZ, which we think has the potential to go up by 25% over the next six months.") Some brokers may well have your best financial interests at heart, but most are just trying to generate commissions. If you use a full service broker, make it clear that you are following a strategy, which you will explain to him/her, and that you do not want to trade until the strategy calls for it. A good representative will understand your wishes and not suggest selling until the strategy calls for it. One advantage to a discount broker is that their representatives are order takers on salary, so they will never call to suggest that you buy or sell.

Recommendation: If you have less than $10,000 available for investment according to a Dow Dividend strategy, buy a unit investment trust. If you have $10,000 or more, open an account with a deep deep discount broker and make your own trades. If you have $10,000 and use a strategy involving five stocks (such as BTD5), and if the broker charges $20 per trade, then the commissions for one year will be $200 ($20 x 2 x 5), which is 2% of your capital. If you are more aggressive and use the MF4 strategy, which involves four stocks, then the commissions are about 1.6%. Assuming that you will continue using the strategy for more than one year and that some stocks will be holdovers (which is quite likely), if you do not rebalance at the end of the year, then your commissions will be a smaller percentage over time. If you have more to invest, say $20,000 or more, than my preference would be to use the two year combined strategy that calls for investing approximately equal dollar amounts in each of the stocks in the combined current year and prior year BTD5 lists. Do not worry about buying "odd lots" (other than a multiple of 100 shares) since there is no longer any penalty or execution disadvantages for such trading.

As explained elsewhere, the best time to execute these strategies is right around the beginning of the year. If it is late in the year, say after August, I would just wait to get started. If you do the calculations, you may be able to see that some stocks are virtually certain to be part of your strategy, so you can buy them whenever you think is a good time. (Example: After the market takes a sharp drop or even "crashes." November 1987 would have been a great time to start buying.) If you are using the two year combined strategy, you will already know five of the stocks for the portfolio: those on the current year's BTD5, which will be next year's prior year list! Earlier in the year, you could buy based on the current rankings and calculations. Another possibility, which is attractive if the market is down so far in the year, is to buy the stocks you would have bought at the beginning of the year. That way your results will be better than if you had started at the beginning of the year according to your chosen strategy. There is no magic right answer. The important thing is to formulate a plan and then stick with it for several years. Doing so should enable you to realize the benefits from following one of the Dow Dividend strategies.