Automatic Income

by Matthew Paulson

  Dividend Stocks Work Great for Retirement Investing

  After you open up an IRA or set up a 401K plan through your employer, you have to decide what kind of investments you want to put your money into. If you’re younger, the standard advice is to put money away into growth stocks that have a good chance to appreciate over time as you get closer to retirement. You will probably do okay owning growth stocks throughout your working years, but they are non‑ideal investments if you’re in retirement because you have to sell shares of the stocks or mutual funds you own to provide for your life‑style. This might work okay when the market is doing well, but selling shares in a declining market will magnify the impacts of market losses. If the market declines by 2% in a year, you have to sell shares that were worth $62,500 a year ago to get $50,000 in cash. This effect, known as reverse dollar‑cost averaging, means the market will need a significantly stronger recovery to get you back to your original account balance. For example, if the market were to decline by 20% per year and you withdraw 4% of your money in a year, you will actually need a 31.6% recovery to get back to your original portfolio balance.

  For people getting ready to retire, the standard advice is to purchase lower‑risk, income‑generating investments such as municipal bonds, corporate bonds, and treasury bills. These investments provide stability and the type of steady income stream that retirees are looking for, but they just aren’t able to generate the yields retirees need in the current protracted low‑interest rate environment. As I write this chapter, a 10‑year Treasury bill pays a yield of just 1.7%. The iShares National Municipal Bond Fund, the largest municipal bond fund, currently pays a dividend yield of just 2.26%. Since most retirees are looking to be able to safely live on at least 4% of their retirement portfolio each year, traditional income investments just aren’t going to cut it until the prevailing interest rates rise to more historical levels.

  Dividend stocks offer the perfect mix of growth investing and income investing. You can build a portfolio of dividend stocks that offers immediate income in the form of dividend payments and long‑term capital appreciation as the prices of your stocks rise over time. You can easily build a portfolio of dividend stocks that offer a yield by 4% and 5% in today’s environment, which will enable you to meet the target 4% withdrawal rate in retirement. You will also never have to sell any shares of the stocks that you own, because 100% of your withdrawals will be funded by the dividend payments that you receive. Since you’re never actually selling any of your shares, you won’t get hammered by the effects of reverse dollar‑cost averaging in the event of a ­market dip.

  Dividend stocks offer true passive income. You receive checks in the mail (or deposits in your brokerage account) every month or every quarter for simply owning a publicly traded company. You don’t have to do anything other than continue to hold on to your stocks. Because companies regularly raise their dividends, the passive income you receive in the form of dividend payments will almost certainly grow over time. There is also no guessing about how much money you can or cannot safely take out of your account, because you can immediately know how much income you can live off of by adding up the amount of dividend payments you expect to receive over the course of the year. Dividend investing isn’t without risk, but the combination of capital appreciation and income they offer make them very attractive investments for retirement.

  Dividend Stocks Have Lower Volatility

  Investors use a metric known as beta to determine the volatility, or systematic risk, of any given company relative to the market as a whole. Beta identifies the tendency of a company’s returns and price swings to track with the broader market. The S&P 500 has a beta of 1.0. Companies that move with the market will also have a beta of 1.0. Companies that have a beta of less than one are theoretically less volatile than the broader market. Securities that have a beta of greater than one are more volatile than the market as a whole. Most technology stocks have a beta higher than one because they are higher‑risk and higher‑growth investments. On the other hand, companies in more stable sectors, such as utilities and consumer staples, will generally have betas of less than one. For example, iShares U.S. Utilities ETF has a beta of just 0.08. That means for every $1.00 price swing in the S&P 500, the iShares U.S. Utilities ETF will move about 8 cents.

  As you might expect, dividend stocks are collectively less volatile and have less systematic risk than the broader market. Most companies that pay dividends and continue to grow them over time are well established large‑cap companies that have long histories of earnings growth. They have more predictable earnings and tend to weather uncertain times better. During market dips, dividend stocks generally don’t fall nearly as much as younger, high‑growth companies do. For example, the ProShares S&P 500 Dividend Aristocrats ETF (NOBL), which tracks the S&P Dividend Aristocrats Index, has a beta of 0.77. If you were to own all of the companies in the S&P Dividend Aristocrats, your portfolio would be 23% less volatile than the S&P 500.

  Having a portfolio with lower volatility won’t give you better returns, but it will help you sleep better at night. Many investors make the mistake of selling when the market is in decline to avoid further losses and only get back into the market after it’s already significantly appreciated in value. By owning stocks that don’t jump around as much, you’ll have much less of a temptation to sell out your positions when there’s a market decline.

  The Psychological Advantage of Dividend Investing

  Dividend stocks have another psychological advantage as well. In lieu of worrying about the day‑to‑day value of your portfolio, focus on the perpetually growing income stream you receive in the form of dividend payments. By changing the metric that you focus on from something that is very volatile to something that will generally move up and to the right, you will be much less tempted to sell your shares during a market decline. You really should be focusing on the amount of income generated by your portfolio anyway, because the amount of income your portfolio generates is really the metric that will matter in retirement.

  In Warren Buffet’s 2013 annual letter to Berkshire ­Hathaway shareholders, Buffet told a story about a 400‑acre farm he ­purchased for his son in 1986. I won’t repeat the story in its entirety, but Buffet used the example of his farm to provide a world‑class commentary about why investors shouldn’t focus on the wildly fluctuating valuations of stocks:

  …If a moody fellow with a farm bordering my property yelled out a price every day to me at which he would either buy my farm or sell me his — and those prices varied widely over short periods of time depending on his mental state — how in the world could I be other than benefited by his erratic behavior? If his daily shout‑out was ridiculously low, and I had some spare cash, I would buy his farm. If the number he yelled was absurdly high, I could either sell to him or just go on farming.

  Owners of stocks, however, too often let the capricious and often irrational behavior of their fellow owners cause them to behave irrationally as well. Because there is so much chatter about markets, the economy, interest rates, price behavior of stocks, etc., some investors believe it is important to listen to pundits — and, worse yet, important to consider acting upon their comments.

  Those people who can sit quietly for decades when they own a farm or apartment house too often become frenetic when they are exposed to a stream of stock quotations and accompanying commentators delivering an implied message of “Don’t just sit there, do something.” For these investors, liquidity is transformed from the unqualified benefit it should be to a curse.

  A “flash crash” or some other extreme market fluctuation can’t hurt an investor any more than an erratic and mouthy neighbor can hurt Buffet’s farm investment. Indeed, tumbling markets can be helpful to the true investor if he has cash available when prices get far out of line with values. A climate of fear is your friend when investing; a euphoric world is your enemy.

  During the extraordinary financial panic that occurred late in 2008, I never
gave a thought to selling my farm or New York real estate, even though a severe recession was clearly brewing. And, if I had owned 100% of a solid business with good long‑term prospects, it would have been foolish for me to even consider dumping it. So why would I have sold my stocks that were small participations in wonderful businesses? True, any one of them might eventually disappoint, but as a group they were certain to do well. Could anyone really believe the earth was going to swallow up the incredible productive assets and unlimited human ingenuity existing in America?

  (source: http://www.berkshirehathaway.com/letters/2013ltr.pdf)

  Dividend Stocks Outperform the Market

  J.P. Morgan Asset Management issued a report in 2013 that analyzed how companies that pay dividends performed compared to companies that don’t pay dividends over a 40‑year period. From January 31st, 1972, to December 31st, 2012, companies that paid no dividends had average annual returns of just 1.6%. Companies that cut or eliminated their dividends had average annual returns of -0.3%. On the other hand, companies that initiated or grew their dividends during that 40‑year window saw average annual returns of 9.5% (https://www.ny529advisor.com/blobcontent/897/96/1323361441857_journey_spring_2013_speaking_investments.pdf).

  It shouldn’t be much of a surprise that companies that pay and grow their dividends have outperformed that companies that don’t, since 40% of returns of the S&P 500 over the last 80 years have come from dividend payments. Let’s imagine that you invested $10,000 into an S&P 500 Index fund at its inception in 1926. If you had reinvested all of the dividend payments you received, your portfolio value would have grown by an average of 10.4% per year and would be worth $33,100,000 by the end of 2007. If you had not reinvested your dividends, your portfolio would have grown just 6.1% per year and would only be worth $1,200,000 at the end of 2007. During the 81‑year period between 1926 and 2007, reinvested dividend income accounted for nearly 95% of the compound long‑term return earned by companies in the S&P 500 (http://www.etf.com/publications/journalofindexes/joi-articles/3869-the-importance-of-investment-income.html).

  If you need further proof that companies that pay strong dividends regularly outperform the market, you need not look further than the S&P 500 Dividend Aristocrats Index. This group of 52 S&P 500 companies that have raised their dividend every year for at least 25 years has dramatically outperformed other market indexes over the last decade. During the 10‑year period ending in September 2016, the S&P 500 Index had an average annualized return of 11.68% with dividends reinvested. During the same period, Dividend Aristocrats Index returned an average annualized return of 16.17%. It’s hard to understate how dramatically dividend‑paying stocks have outperformed the broader market given that they have outperformed the S&P 500 by a whopping 4.5% every year.

  You Can’t Fake Dividend Payments

  When publicly traded companies announce their earnings each quarter, the numbers presented are often largely a product of accounting and may not be truly representative of the company’s actual financial health. Skilled accountants and unscrupulous executives can make a bad company’s financial look healthy on paper. This is exactly what happened with Enron in the late 1990s. On paper, the company’s financials looked great. Behind the scenes, the company was transferring its losses and debts to offshore corporations that weren’t included in its financial statements. The company engaged in numerous sophisticated accounting transactions between various legal entities to eliminate unprofitable entities from its financials. Everything looked alright on paper and the company’s stock price remained strong and it had a sterling credit rating, but it was a house of cards behind the scenes and eventually collapsed.

  Accounting numbers can be manipulated, but you can’t fake dividend payments. Either a dividend payment appears in a company’s shareholders’ brokerage accounts, or it doesn’t. There are no accounting tricks that can make a dividend payment look stronger than it actually is and you know that the company at least has enough money to make its dividend payments. This isn’t to say that dividend payments necessarily mean that a company has strong cash flow, because companies will occasionally borrow money to pay their dividend during cyclical downturns. For example, Chevron has been borrowing to maintain its dividend recently because of cyclically lower oil prices. However, major financial institutions would never lend Chevron the money to cover its dividend payments if they didn’t believe that it would be able to repay those obligations in the years to come.

  Dividend Payers Tend to Be Healthy Companies

  Companies that pay strong dividends and steadily raise them over time tend to be very healthy and shareholder‑friendly. One of the best signs of a company’s overall health is having strong positive cash flow (having new money come into the company) and a company cannot pay dividends over a long period of time unless they have the cash flow to support their dividend.

  Strong dividend payers also can’t carelessly acquire companies or launch speculative growth projects nearly as easily other companies that have similar cash flow but don’t pay dividends. They have to cherry‑pick the growth opportunities that are most likely to create shareholder value with their artificially constrained retained earnings. Any company that can return more and more profit to its shareholders each year for decades must be doing something right.

  Dividend Stocks Protect Against Inflation

  Dividend‑growth stocks offer a much better hedge against inflation than bonds and other fixed‑income investments. Most bonds pay a fixed interest rate over the life of the bond, meaning the interest payment you receive is the same in the first month you own the bond as it is through its maturity (which could be more than a decade down the line).

  During inflationary periods, each successive interest payment that you receive has less purchasing power than the last. Because the bonds you own will be lower than the prevailing interest rate, the value of your bonds will decline to match the bond market’s current rates.

  Dividend stocks won’t be immune to the effects of inflation, but publicly traded companies can at least raise their prices to match inflation, which will then be reflected in its annual earnings and dividend payments.

  According to data collected by Robert Shiller, dividends from the S&P 500 have grown at an annual rate of 4.12% between 1912 and 2005, while the consumer price index (a commonly accepted measure of inflation) has risen by 3.3% annually during the same period. As long as a company grows their dividend as fast as or faster than the rate of inflation, shareholders’ dividend payments won’t lose any purchasing power.

  Risks of Investing in Dividend Stocks

  There’s a lot to like about dividend investing, but dividend stocks aren’t without risk either. There are several investment risks associated with dividend stocks that you should be aware of and factor into your investment decisions:

  Tax Policy Risk – Currently dividends receive preferential tax treatment under the U.S. tax code. Qualified dividend payments are taxed at capital‑gains rates, which are either 15% or 20% depending on your tax rate. It hasn’t always been this way, though. As you’ll learn in a later chapter, Congress has toyed with dividend‑tax policy several times over the last decade. If Congress were to remove the preferential treatment that dividend payments receive, dividend stocks would be less attractive investments and would likely fall in price.

  Interest Rate Risk – Dividend yields are regularly compared to the interest rates offered by other fixed‑income investments on a relative basis. When interest rates offered by risk‑free dividend investments rise, dividend stocks become less attractive relative to their fixed‑income counterparts. As interest rates rise, there will be natural outflows from dividend stocks that will lower their share price and drive up the yield of dividend stocks.

  Risk of Price Volatility – Dividend stocks have the same risks that any other publicly traded companies have. Their prices will fluctuate as market conditions change. While stocks generally perform well over the long term, investors must be prepa
red for years where their share prices decline significantly. If you can’t stomach a 30% decline in the price of your dividend stocks in a year, dividend stocks might not be the investment for you.

  Risk of Dividend Payment Cuts – When a company faces economic hardship, its ability to generate cash flow and thus make dividend payments will be constrained. If a company doesn’t have the cash flow to support its dividend over the long term, it will have to cut its dividend eventually. The share prices of companies that cut their dividends tend to take a significant beating in the market, so it’s important to monitor the companies in your portfolio for clouds on the horizon. If the company’s dividend appears unsustainable, you should try to get out before the company announces it will be cutting its dividend.

  Wrap-Up

  There are a lot of qualitative reasons to like investing in dividend stocks, but what really matters at the end of the day when comparing investment options is risk‑adjusted after‑tax performance. In other words, how much of a financial return am I going to get for the level of risk I am taking on after all taxes are paid? In this chapter, I have shown you how dividend stocks have handily outperformed the S&P 500 and other asset classes over the last few decades. I have also demonstrated how dividend stocks are less volatile and have lower systematic risk than other publicly traded companies. Dividend payments also receive preferential tax treatment under current U.S. tax law. While dividend stocks aren’t without risk, the numbers demonstrate they are very attractive relative to other investments.