With investors earning next to zero on money market accounts and CDs, it’s no surprise that investing for dividend income is “in” again. As portfolio managers, our job is to provide investment solutions for clients nearing or in retirement, and usually that means generating a fair amount of sustainable income to cover monthly expenses. For the first time in fifty years, the average dividend payout on stocks in the S&P 500 index is actually higher than the payout on 10-year Treasury bonds, opening up some exciting new income opportunities for clients. Here’s a short introduction to the world of dividend investing:
Compared with many other investments, stocks are now offering very attractive income flows. “A portfolio of high-quality, dividend-paying stocks not only offers the potential for higher yields versus cash and fixed-income alternatives, but also offers the prospect for growth in income and capital appreciation,” says investment firm Morningstar. From 1926 through 2010, the total return on large dividend-paying stocks averaged almost 10% per year, beating out both corporate bonds (5.9%) and long-term government bonds (5.5%). Dividend-paying stocks have outperformed non-dividend payers in four decades out of five. Plus, unlike many bond payments, dividends can grow over time. In 2011, U.S. companies increased their dividends by $50 billion, and that on top of an earlier $26 billion hike in 2010.
What to avoid
First, realize that dividend-paying stocks are still stocks. That means they are subject to the same market risks and should only be used as long-term investment solutions. If you can’t accept the inevitable market ups-and-downs, avoid stocks and stick to cash and bonds. Also, many stocks with extraordinarily high dividends have hidden flaws, like poor growth prospects, weak balance sheets, and uncertain cash flows that could lead to dividend cuts. Super high dividends are usually a danger sign, so stay away. In a study of stock returns since 1928, the highest-yielding stocks performed worse than the next highest yielding group, so stick to stocks with healthy, but not stratospheric, dividends.
What to look for
For client portfolios, we select from a stable of outstanding low-cost funds and ETFs that target companies with large and growing dividends. Depending on the investment mix, yields can range from the 2% S&P 500 average to above 6%. The biggest dividend-payers in the S&P are now consumer and health care companies, not banks and utilities, so today’s dividend portfolios seek out opportunities in blue-chips, real estate, multinationals, and other sectors. If you are a growth and income investor, it’s time to discover how dividends can keep your portfolio growing for years to come!