Should I Invest in Dividend Stocks?
When I decided that retirement at 65 wasn’t for me it was only a matter of time before I started to take a good look at owning stocks.But not just any stocks would do, I needed stocks that pay me just to hold it. I needed dividend stocks.
And not just any dividend stocks will do, in order to hedge against inflation I needed strong reliable companies with an excellent history of constantly raising their dividend payout. The trick, of course, is picking the winning horse. But more on this later. First, let’s answer a basic question, up front: what is a dividend stock any why are they a key part of my investment strategy?
In a nutshell, when a company takes in revenue it can either decide to reinvest that capital into its operations or it can decide to pay a portion of that revenue out to its shareholders in the form of a monthly or quarterly dividend (well, it could also buy back shares, but that’s not important right now). There are several advantages afforded to investors by these kind of securities. Such as:
Steady passive income – You get paid just to own it. And many companies pride themselves on their dividend paying history. And a company that sees paying me as part of their company’s identity is A-OK in my book.
Increased value over time – Even taking into account depressions, recessions, and “price corrections”, the value of many of the large mature “blue chip” companies you find in the market have gone up, over the long term.
Advantaged Tax rate – Recognizing that this could change at any year, right now the tax rate (“Capital Gains” tax) applied to dividend income is only 15% – 20%, depending on your own tax bracket. This very fact allows me to keep more of my own money.
DRIPs – “Dividend Reinvestment Programs”. These allow you to automatically reinvest your dividend payment back into the company and buy more shares. You can even buy fractions of a share, which will pay an equivalent fraction of the dividend, allowing you to compound your returns even faster AND avoid paying broker trading fees.
Reduced risk – ….sort of. Most typically, the kinds of companies that not only pay a handsome dividend but also have a strong history of raising that dividend each year are large, solid, and mature companies that have weathered storms in the past and can do so in the future. Companies like these are usually on more financially solid ground than young companies.
“Low sophistication” investing – I am a “buy and hold” type of investor. This strategy doesn’t as much require me to understand the “butterfly effect” that seem to cause the daily fluctuations of the stock market, but rather to understand a company’s fundamentals and financials.
Of course, for every advantage in the stock market there seems to be an equal but opposite disadvantage. By valuing the characteristics above I am also, by necessity, accepting the disadvantages below:
Dividend reduction – A company that pays a dividend can decide to slash, or even eliminate, their dividend when they hit rough waters. And this can be done with little to no warning.
“Abandon ship” devaluation – Many dividend investors will dump a stock if the company reduces their dividend payment. And if a sufficient number of investors do this then it will cause the price of your stock to drop, even if the dividend reduction was necessary to the company’s long term health.
“Double” taxation – (Can’t remember where I stole this example from. Anyone got the link?) Imagine you’re a parent and you just got your paycheck, on which you of course paid taxes. Then you go home and give your kids their allowance on which they have to pay taxes too! That is what happens with a dividend. The company pays taxes on their revenue, and you pay taxes on your dividend income. Uncle Sam gets to double-dip on the same dollar.
False sense of security – Remember Enron? The despicable company that cooked its books to fool investors and went bankrupt in 2001? Yeah…they paid a dividend. While it is difficult to believe that a giant like Coke or Johnson & Johnson could suddenly implode for any reason, these things can happen. “Blue chip” is not synonymous with “bulletproof”.
High-yield trap – The inexperienced investor can often fall victim to absurdly high yields. We all want to get the highest yield possible, of course, but more important for long term investors is the question of how long the company can sustain their yield rate. A company with a dividend yield rate of 3% or 4% has a better chance of maintaining that rate for the long term than an equivalent company that is trying to attract investors by offering 8% or 10%.
“Don’t Lose Money”
Warren Buffett tells us that there are two rules of money: “Rule #1. Don’t lose money. Rule #2. See rule #1“. And on the surface that can seem frustratingly obvious, but when you dig just a bit deeper you realize that his remark is not just a wry comment, but also an admonition for responsible investing. Too many investors chase returns and throw their money in with a company or a mutual fund that seems to promise better than market average returns (we’ve all done it). And overwhelmingly these investors end up limping away to lick their wounds. And some investors, inexperienced ones, often never return; swearing that the entire game is just a crap shoot and you have to be a crook to make any money.
Years ago, having taken this one on the chin myself, I wanted to find a better way to invest in dividends. Then I stumbled upon a curious term, “Dividend Aristocrats“.
What is a Dividend Aristocrat?
Put succinctly, the dividend aristocrats is a list of companies who have increased their dividend every year for 25 or more consecutive years. These are often well known companies you know by name. Brands like Coca-Cola, AT&T, McDonald’s, Johnson and Johnson, and Chevron.
So what does all this mean in dollars? Well, if you hop over here you can run your own numbers, but say you had $10,000 and invested it in Johnson & Johnson on August 1st, 1995, reinvested the dividends, but didn’t add any new money to it. Well, by the end of 2014, you’d be sitting on a cool $91,347.53! An 813% total return! (And just for comparison, without reinvesting the dividends you’d only have $74,107.01; a 640% total return).
Another advantage these companies have is that they are easy to understand – even my six-year-old niece knows what McDonald’s sells – and it is often these companies who sell simple to understand products and services that can weather market storms; no matter how bad the economic weather gets, people are always going to buy soap, hamburgers, and the latest iPhone. And just as a general rule, if you don’t understand what a company does then you shouldn’t be investing in it.
The Dividend Decision
Investing for dividends is a very un-sexy way of building wealth. It is the “tortoise” in the race. This is a simple fact. If it weren’t then we’d see stock “expert” bozos on TV jumping up and down every time someone announced a dividend increase.
Dividend investing is a long term strategy that must be, at some level, a part of every income investor’s portfolio. They are easy to acquire, enjoy a nice tax advantage, and are very liquid. If cash flow is your goal, then in this investor’s not-so-humble-opinion there is very little reason not to invest in them.
See you at the top!
Disclosure: I currently own shares in both AT&T and Chevron.
Disclaimer: The author is providing opinion and is not qualified to, nor attempting to, issue investment or tax advice. Consult with a professional before taking any action