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Do you believe investing in dividend stocks will provide income in retirement? Contrary to what some investors may believe, dividend stocks aren’t necessarily safe, guaranteed or foolproof. The reality is dividend stocks may have some risks and nuances to consider before investing. Some dividend-yielding assets might be an appropriate part of your retirement portfolio. If so, understanding how dividend reinvestment works and if it is right for you are important considerations.
When a company makes a profit, one of the ways to distribute some of the earnings to shareholders is by paying a dividend. You may have seen dividends as a line item in your brokerage statement. Dividends are different from a capital gain (another item that could appear in your brokerage statement), which is the profit you gain when you sell a stock.
Some investors confuse earned interest with dividends, but there is a difference. Interest is a return that your principal has earned, whereas dividends are a return of your principal. Compound interest is the combination of interest earned on your initial investment plus interest earned on accumulated interest on that investment. Dividends don’t compound unless they are reinvested.
Dividends are one way for companies to return value to shareholders. They can also reinvest cash into the company to grow profits, buy back shares or make lucrative acquisitions.
There are two main types of dividends—cash and stock. Cash dividends are paid by the company in the form of cash. Stock dividends are additional shares the company distributes to shareholders. Both types of dividends may be recurring or only happen once.
Investors often think of cash dividends as free money. That isn’t necessarily the case. The cash comes from the stock price itself. When a firm pays a dividend, the share price falls by about the amount of the dividend, all else being equal. This isn’t to say dividends are necessarily bad, but dividend-paying stocks shouldn’t be considered automatically superior to low- or non-dividend paying stocks.
Some investors rely on dividend income for cash flow, but you can get portfolio income from other sources. One strategy is selectively selling stocks incrementally for cash flow—or what we call “homegrown dividends.” While this strategy carries the cost of trading commissions, it is a flexible and potentially tax-efficient way to generate cash flow, especially for larger portfolios. You can sell stocks at a loss to offset realized capital gains, or you can selectively pare back over-weighted positions.
Dividends aren’t guaranteed. Companies can cut back or eliminate dividends at any time, especially those going through tough times. If you are relying on dividend income for necessary expenses, you could find yourself in a difficult position.
If you invest in only dividend stocks, you may end up with a less diversified portfolio. Dividend-paying stocks tend to concentrate in sectors such as consumer staples and utilities. If these sectors fall out of favor, portfolio returns may slump.
Dividend stocks may have an appropriate place in your investment portfolio—but focusing solely on this type of stock may not be the best option for your income needs.
If you do use dividend-yielding securities in your retirement portfolio, you need to decide how to use those dividends. Some investors prefer to let dividends accumulate as cash in their accounts. If you don’t need cash flow from your portfolio, you might consider dividend reinvestment. By reinvesting your dividend income, you can invest in additional shares, and potentially set up your portfolio for compounding growth.
Some companies may offer Dividend Reinvestment Plans (DRIPs) that allow for automatic reinvestment. If you decide to reinvestment your dividends, DRIP investing may offer advantages. If you do not wish to use a DRIP, you may consider taking dividends as cash and then reinvesting on your own.
Dividend income might be a useful part of your long-term investment income strategy, but don’t overlook the benefits of compounding interest or the flexibility of a different income source. Whether you are in retirement or have many years to go before retirement, your focus should be on total return, of which dividends are just a part. If you focus only on dividend yield, you could be missing out on the best strategy and portfolio for your needs.
Dividend reinvestment could be a useful part of your retirement strategy. If you need help putting together a plan, you might consider working with a financial professional.