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Your retirement portfolio may be made up of a number of dividend-yielding securities. These may include dividend-paying stocks, mutual funds, exchange traded funds (ETFs) or real estate Investment trusts (REITs). For some investors, dividend investing is their primary plan for retirement income, while for others, dividend income may be just one part of their re tirement income strategy.
When focusing on dividend income, it’s important to understand what dividends are, and potential drawbacks if you plan to retire primarily on dividend income. Some investors are under the impression that dividend-paying stocks are safer than other categories of stocks. Some investors may believe that the payouts from dividend stocks are guaranteed. However, dividends are not guaranteed or a foolproof way to receive retirement income.
Stocks, mutual funds and ETFs are often classified according to style—growth vs. value. There are differences between these styles, and it is a good idea to be familiar with them before selecting investments.
Growth stocks are companies likely to offer greater capital appreciation potential by growing their earnings faster than average. Value stocks are those that may be viewed as underpriced and have potential for price appreciation when the market reconsiders their value. Over time stock categories go through periods of outperformance and underperformance. One class or style isn’t necessarily superior to others for all time.
Which stocks are more likely to pay dividends? There is no hard-and-fast rule, but you are likely to see some overlap between high-dividend stocks and value stocks. High-dividend stocks also tend to be concentrated in certain sectors
Dividends are just one way for companies to share their profits with investors. Stocks can also provide return to shareholders in the following ways:
Some investors think of dividend payouts as guaranteed, safe or free. They aren’t. A company can reduce or eliminate the payouts at any time, which could be a risk for retirees who plan to rely solely or primarily on dividend income. Investors may also think a company that pays dividends to its shareholders is more likely to be healthy and profitable. That too may be an inaccurate assumption.
Investing in a dividend stock may seem like a buffer against volatility, since you could receive a payout even if the stock market is down. But keep in mind that when a company pays a dividend, the share price falls by about the amount of the dividend, all else being equal. This typically happens on the ex-dividend date. The general assumption is the stock price will drop by the dividend amount on that date, but that doesn’t always happen. Other factors that impact the stock price may come into play and cause the price to rise or fall.
Another potential misconception some dividend investors have is that dividend income is similar to interest. Both are technically income—that is how you report them on your tax returns. And there is nothing inherently wrong with either as a cash flow resource. The main difference is that interest is a return on principal whereas dividends are a return of principal.
If you include dividend stocks as a part of your retirement planning, you should be aware of several considerations, including growth vs. yield, inflation’s impact and diversification.
Dividend growth and dividend yield are two ways to evaluate dividend-paying stocks. Dividend growth is how much the dividend’s value has grown over time. Dividend yield is the ratio of the dividend’s value to the stock’s price.
As inflation rises, purchasing power is reduced. Dividends don’t necessarily keep up with inflation, so your purchasing power could fall over time. Since 1925, inflation has averaged approximately 3% per year.[i] If you rely on dividends for living expenses, you should understand how inflation impacts purchasing power over time. If the dividend growth rate is less than inflation, your money will have less purchasing power.
In addition to inflation’s impact, investors should also consider whether their portfolio is well-diversified. Many dividend-paying stocks are in certain sectors such as consumer staples and utilities. If you are primarily investing in the highest dividend-paying stocks, it could inadvertently expose your portfolio to concentration risk. The problem with over-concentrating on specific sectors is their growth tends to be cyclical—they cycle in and out of favor. When the sectors you are overexposed to underperform, stock prices will be lower and additionally, your dividends could be impacted. This is one of the reasons your portfolio investments should be diversified appropriately.
There are several ways in which a retirement portfolio can generate cash flow in retirement. Instead of relying on dividends for cash flow, you can selectively sell individual stocks, an approach we refer to as “homegrown dividends.” As part of your regular portfolio maintenance, you could prune back outsized positions or sell stocks or other assets that no longer make sense to own. While investors can incur trading commissions through this strategy, it is a flexible and potentially tax-efficient way to generate cash flow in a taxable account, especially for investors with larger portfolios.
Every investment comes with a possibility of loss, whether it is a common stock, high-dividend stock, ETF or any other security. Dividend investors should weigh the benefits and drawbacks of relying on dividend income for the long term. Whether in retirement, approaching retirement or 40 years out, investors should care about total return—price appreciation plus dividends—rather than just dividend yield.
If you want to learn more about what strategy could work for you—no matter where you are in your retirement planning—contact Fisher Investments today. We may be able to help.
[i] Source: FactSet, as of 02/12/2018. Based on US BLS Consumer Price Index from 12/31/1925 to 12/31/2017, average annualized inflation of 2.91%.