The following is the second of a series of weekly articles in which Sheryl will provide overviews of investment options that offer alternatives to bank accounts. Last week's article covered REITs. As with any investment that's not an insured deposit account, there are risks. Some may feel that these risks are worth it for the chance of higher yields. The focus of these articles will be on conservative investments that may appeal to some savers who want a chance of higher yields and minimal risk.
Investors haven’t forgotten their mega losses when the market tanked just a few short years ago. It’s not surprising then, that some investors are rethinking dividend stocks and deciding they should be in their portfolio.
What is a dividend stock? Simply put, for every share of a dividend stock that you own, you are paid a portion of the company's earnings. You benefit merely from owning the stock.
Dividends have played an important role in the returns achieved by investors. For example, dividends have accounted for about 50% of the S&P 500 Index’s total return since the 1940s, says ReKeithen Miller, a certified financial planner with Palisades Hudson Financial Group. In low interest rate environments like now, dividend stocks can outperform because investors value the sometimes higher yields they can obtain versus investing in bonds. Dividend stocks can provide better inflation protection than bonds over the long term, since companies tend to increase dividend payments over time, unlike interest payments from bonds, he points out.
Dividend-paying stocks tend to be established companies in relatively stable industries. "Think Johnson & Johnson, Wal-Mart, Exxon Mobil, to name a few," says Miller. "Unlike growth stocks where returns are mainly from capital appreciation, dividend stocks take a page from Jerry Maguire and they show investors the money," says Miller.
Dividends offer growth when the stock market is sideways or bearish. "They help you continue to grow your investments even in down markets. In other words, even when capital appreciation is negative, dividends are always positive and therefore help investors cushion the downturn," says Stephanie Genkin, a financial planner and adjunct instructor at New York University’s School of Continuing and Professional Studies Department of Finance & Law.
Some investors value dividend stocks because it’s hard to use accounting gimmicks to manufacture a dividend. A company cannot sustain making dividend payments unless it is generating real earnings from operations, says Miller.
What you need to know
For all the advantages of dividend stocks, that’s not to say there aren’t some considerations and like all investments, you need a strategy.
"Stocks are not bonds, in that they are not required to pay a steady dividend, or any dividend at all. This makes the income component of the return to investors much less dependable. Bondholders are always paid before equity holders. Bonds are inherently less risky and can therefore be evaluated more for their yield," says Tyler Linsten, an investment advisor with Alder Cove Capital.
In fact, just because a company pays a dividend, does not make it "safe," says Kirk Chisholm, wealth manager and principal of the Innovative Advisory Group. "There can be companies that pay out high dividends and they end up being very risky stocks."
Some advisors, like Genkin, say seniors should not rely too heavily on dividend stocks, as a replacement for the current low yield of bonds and CDs, as they do carry more risks.
Realize too, that when a stock pays a dividend, the price goes down to reflect the dividend payment. "So if a $20 stock declares a $1 dividend, the price is adjusted down to $19. The investor really does not gain because the value of the position is still $20, $19 in stock and $1 in cash. The company’s earning must grow by another dollar per share to replace the dividend that was paid out. Dividend is probably the most understood financial term," says James Winkelmann, founder, Blue Ocean Portfolios.
Don’t focus primarily on yield. Linsten explains that a high dividend yield in no way indicates a solid business or guaranteed high return to investors. "Does the stock have a high yield because the market is expecting the company to cut the rate at which it pays dividends (or potentially all dividends)?" he asks. Many factors are important to consider beyond just the nominal dividend yield. A stock could be yielding 10%, but it might be because shares have plummeted recently, and a dividend cut is soon to follow, or business fundamentals have deteriorated, or the CEO abruptly resigned, or any number of things, points out Linsten.
In fact, beware of companies with a very high dividend payout. "There’s a tipping point. It could actually be a signal or an underlying problem. If it seems too good to be true, it’s likely a sign of bad things to come," warns Genkin.
Go for consistency. "Consistent dividend payment is important. Look for companies which have a long history of paying out dividends. Companies which have a long track record have a moral obligation to continue to pay the dividends in a similar pattern as investors have been accustomed," says Chisholm.
Look for companies that continually raise their dividends. "This pattern of raising dividends for shareholders is a good sign of a company that is profitable and well managed. Finding a company that has this pattern will allow dividend investors to find a yield that could outpace inflation if the dividend is raised in an amount higher than the rate of inflation," says Chisholm.
Building your portfolio
If you don’t want to pick individual dividend stocks that have raised dividends, you can invest a chunk of your portfolio in a low cost dividend appreciation index fund, advises Genkin.
Miller recommends investors gain exposure to dividend stocks via mutual funds and Exchange-traded funds (ETFs) because of the added diversification benefit. He is sweet on Vanguard’s Dividend Appreciation ETF (VIG). "It is a solid offering. The fund’s strategy values consistency of dividend payments over having the highest yield."
Of much importance too, says Michael Rankin, a private wealth advisor with Integrated Financial Partners, is to do a self assessment. He says that if you have many years left in the market, you would probably find comfort knowing that your dividend reinvestments were giving you some great purchase prices during a recession. If you only need to strip out your dividends for living expenses, you may still be fine knowing that your needs are met and your investments will remain invested and probably provide a nice inheritance down the road. If however, your income needs dictate that you have to make systemic withdrawals against principal in order to maintain your lifestyle, you could end up needing to modify your lifestyle due to declining principal, he cautions.
The bottom line, he says, "Understanding your own needs will help you blend the traits of dividend paying stocks into successful income and investment planning."