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Should I invest in dividend stocks to generate income?

by John Levan | Contributor
November 3, 2020

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For most retirees, safety is their priority when designing an income-generating portfolio. So, should they add dividend stocks to enhance their income? In many cases, this can be an excellent strategy for several reasons.

Warren Buffett is likely the most well-known and respected stock investor who has ever lived. He is CEO of Berkshire Hathaway, a multinational conglomerate headquartered in Omaha, Neb. Buffett has selected the majority of stocks that make up the company's $400 billion-plus portfolio. And two-thirds of them are dividend payers.

Now, does that mean that because billionaire Buffet holds dividend-paying stocks in his portfolio, the typical retiree of average means should follow suit? The answer is a definite “maybe.”

What are dividends?

Some companies distribute their earnings to shareholders by paying dividends. When a company pays a dividend, each share of stock that an individual owns entitles them to a dividend payment. For example, someone owns 100 shares of XYZ stock, and the company is paying a quarterly dividend of $.25 per share. That person would receive $25 from the company. The dividend is typically paid in cash, although it could be in the form of additional shares.

Not all companies pay dividends, preferring to let the money remain in the company to help it grow. And not all dividends are distributed quarterly. Some companies also pay monthly or annually.

Which stocks commonly pay dividends?

Larger, established companies make up the bulk of dividend-paying stocks since most of them no longer need to reinvest all of their profits. For instance, the S&P 500 is the stock market index made up of 500 large companies, and nearly 85% of these companies currently pay dividends. Specific industries, such as utilities and telecommunications, are also more apt to pay dividends.

Many of these companies have long histories of paying dividends despite unfavorable market conditions or other factors. That’s why many retirees are comfortable investing at least some of their retirement savings in dividend-paying stocks.

What is dividend yield?

Yield helps investors understand the relative value of a company's dividend payment. It is given as a percentage, and it measures the return on investment an investor receives from the company's dividends. Since companies have different share prices, it isn't easy to compare set dividend amounts among several companies. Dividend yield provides a more accurate way of making that comparison.

Calculating dividend yield is relatively straightforward. Divide the stock's annual dividend amount by its current share price. Take the previous example of XYZ stock with an annual dividend payment of $1.00 per share and a $50 per share price. Divide $1.00 by $50, and you will arrive at a 2% dividend yield, which is in line with the average yield of 1.91% for dividend stocks.

Stocks vs. CDs: Sounds like an easy decision

Yes. For many, the decision to add dividend stocks to a retirement portfolio to supplement income makes sense. However, remember that stocks — even the stocks of large, stable companies — will fluctuate in value. And ultra-conservative investors who will lose sleep when their stocks retreat might find comfort in the safety and insurance that lower-yielding CDs offer.

However, for most retirees, relying on companies that pay safe and consistent dividends for at least a portion of their retirement income assuages most of the worries that come with the ebb and flow of the stock market. Those who focus on dividend income that grows over time – instead of the noise caused by volatile stock prices — will withstand the emotional risk that comes with investing.

Choose companies that have a history of increasing their dividend

One of the benefits of owning dividend stocks in retirement is that many companies increase their dividends over time, helping offset inflation. According to the Wall Street Journal, over the last 50 years, the S&P 500’s dividends grew at an average rate of 5.7%, outpacing the average 4.1% inflation rate.

One stock market index, the S&P 500 Dividend Aristocrats Index, tracks large, high-quality stocks in the S&P 500 that have raised their dividend every year for at least 25 straight years.

While past performance does not necessarily predict future results, retirees who receive dividend income are in an excellent position to protect their purchasing power with the stocks that grow their dividends. And even though dividend stocks are not thought of as a growth investment, they can increase in value over the years, making capital gains another source of profits for retirees.

Spread out your risk with mutual funds or ETFs

Some retirees like the idea of dividend stocks but don't feel secure buying just two or three individual stocks. They might consider a low-cost index fund or an exchange-traded fund (ETF) specializing in dividend-paying companies. These funds track the performance of a benchmark index — for instance, the U.S. Dividend Achievers Select Index — while investing in hundreds of individual stocks with a record of increasing dividends over time.

Although a portfolio of dividend-growing stocks will experience some swings in market value, a well-chosen portfolio should generate both income and long-term growth. Note that even during the 2007-08 global financial crisis, over 230 companies increased their dividend!

How do dividend stocks compare to non-payers in the S&P 500?

The following table shows the average annual returns and volatility of the S&P 500 according to their dividend policy. It is divided into four categories: dividend growers, companies that didn't increase their dividend (no change), dividend non-payers and dividend cutters and eliminators. Beta refers to the measure of risk that indicates price sensitivity relative to the S&P 500 index.

Table showing returns of dividend stocks

Higher returns with lower volatility

As you can see, companies that grew their dividend experienced the highest returns with less volatility. Conversely, non-payers’ performance was significantly lower with higher volatility, while dividend cutters and eliminators fared worse.

While no one can predict equities' future, this 45-year performance record shows why dividend stocks rate serious consideration in a retirement portfolio.

Alliance America can help

Alliance America is an insurance and financial services company. Our financial professionals can assist you in maximizing your retirement resources and achieving your future goals. We have access to an array of products and services, all focused on helping you enjoy the retirement lifestyle you want and deserve. You can request a no-cost, no-obligation consultation by calling (833) 219-6884 today.

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