July 20, 2011
What Everybody Ought to Know About Dividend Paying Stocks
All too often lately, I have heard people talking about their individual stock holdings and the income they are providing them in retirement. They love mentioning how they are receiving quarterly income from these companies regardless if the stock market is trending up or down. The stockbrokers refer to this as the “get paid while you wait” way to invest in the market. What they are referring to are dividend paying stocks, and with interest rates where they are today, they seem to have quite the appeal with many investors in retirement. The theory is that dividend paying stocks are providing both a systematic payout method and stability in their portfolio. Are they being misguided?
Thoughts to consider:
1. Dividends are not a “free lunch”: Stocks that pay dividends tend to be large companies who focus less on growth and instead pay out a portion of current income in the form of a dividend to its stockholders. Non-dividend paying stocks reinvest back into the company in an effort to provide more opportunity for growth. All else being equal, dividends are a trade-off, taking current income for slower growth in the company’s sales, earnings, and stock price.
2. Remember to diversify: Most dividend paying stocks are large capitalization companies. These are great to have in a portfolio, but only if they are accompanied by other equity investments to provide some diversification. We all remember what the market did in 2008, but what many forget is that it was the smaller US companies and international stocks which really helped drive the market back upwards in the following two years.
3. How much risk are you taking in your portfolio?: If you own a portfolio of dividend paying stocks then the answer is probably too much. Just because a stock is providing you income does not make it any less volatile. There is an inherent risk in owning stocks, which must be offset with a fixed income investment (bonds) for both the stability and further diversification it brings to your portfolio.
4. Dividend paying stocks are not an alternative to bonds: The “Dogs of the Dow” are a well-known index of dividend paying stocks. How well did the strategy do in the recent market downturn? Not so great. As the S&P 500 Index plunged 37% in 2008, the Dogs of the Dow recorded a negative 38.8% return. Bonds held up quite well during the same period. As measured by the Vanguard Total Bond Market Index Fund, bonds were up 5% over the same period.
Coming up with a systematic way to provide yourself with income in retirement is very important, but you want to make sure you do so in a way that makes sense from a risk standpoint as well. Dividends from a stock portfolio will fulfill the income need you may desire at retirement, but it may come at a cost! We, as investors, can’t control the direction of the stock market, yet we can control our exposure. This becomes even more important when you are nearing retirement and why proper diversification is crucial. Investing is a long road and when you reach retirement you are only halfway there, so make sure to work together with your advisor to come up with a strategy that makes sense for you!