The Money Class

by Suze Orman

  And I know it is creating a dangerous problem for many of you. Because your bank deposits and CDs aren’t producing enough income, you are withdrawing more of your principal to make up the difference. Using the same example, if you needed to make up the $10,000 shortfall, you would withdraw the money from your $250,000 balance, leaving you $240,000. That leaves you less money to be earning interest. And you and I both know that if you have to withdraw even more—and keep it up for years—you are putting yourself in danger of running out of money. I cannot imagine a more harrowing way to spend your golden years than watching your funds dwindle.

  So what I am about to suggest is a strategy that our grandparents and their fellow retirees used to pay their bills years ago. If you focus your investments on dividend stocks with a long history of paying out, you will have yourself a steady income stream. As I write this in early 2011 there are many high-quality stocks that have dividend yields of 3% to as much as 6%. Compare that to the 1% you can currently earn on a short-term CD and you can see why I think dividend stocks can be a great solution to your income shortfall.

  Now, that said, it is absolutely true that any stock investment is going to be more volatile than investing in a CD or a short-term bond fund. I do not recommend that you invest any money you think you will need within 10 years or so in stocks. But remember how we talked earlier about the need to own stocks as well as bonds and cash? The fact is, the stock portion of your portfolio can do double duty for you right now. It can provide the opportunity for long-term growth that we know is important given the odds you will live a long time. But while you are investing for that long-term growth you will also receive an income payout—the dividend—that is in fact higher than what you can get in bonds these days. And unlike bond interest rates that are fixed, a dividend can increase over time. That’s an important way to keep your money growing along with inflation.

  I want to repeat this important point: As long as you know you will not need to sell a stock in the next 10 years or so to cover your living expenses, dividend-paying stocks are a great way to generate income.

  I think the smartest way for most of you to invest in dividend stocks is by investing an exchange-traded fund (ETF) that specializes in dividend-paying stocks. An ETF will typically own at least a few dozen individual stocks, so with one investment you will own a diversified portfolio of stocks. For those of you with at least $100,000 or so to invest in stocks, direct investment in individual issues can indeed make plenty of sense. That is how I invest in dividend stocks. Later on in this class I share some guidelines for how to build a portfolio of individual dividend-paying stocks. But I want to stress that I think using ETFs that focus on dividend-paying stocks is a great way to own a diversified portfolio of dividend stocks.

  Why do I want you to be protected by diversification and not just buy individual dividend-paying stocks? Let me answer that one by giving you an extreme example. For years BP, British Petroleum, paid shareholders 6% dividends, month in, month out. Then in April 2010, disaster struck in the Gulf of Mexico when a BP oil rig exploded, killing eleven people and touching off an environmental disaster. The stock price crashed, falling more than 50% by July, when the spill was brought under control, and the firm stopped paying its dividend for 2010. And as some of you may have experienced, in the wake of the 2008 financial crisis many banks abolished or sharply reduced their dividend and have yet to restore those payments. Diversification affords protection from the volatility of any given individual stock.

  I also want to stress another point about ETFs that invest in dividend-paying stocks: While I think they deserve to be a permanent part of your retirement portfolio given their ability to help you manage inflation, at the same time I recognize that there is indeed much greater peace of mind for many of you by sticking with bonds. As I have explained, the current interest rate environment makes it likely that we will see bond rates rise in the coming years. Until that happens, I hope you will consider adding dividend-paying ETFs or stocks to your portfolio to produce more income. But then, once you see rates rise to a level that you are comfortably certain will provide you plenty of income, you can consider redirecting more of your money into bonds, if that is the truth that will make you feel more secure.

  STOCK DIVIDEND BASICS

  Some publicly traded companies choose to give a portion of their profits back to their shareholders over the course of a year. That payment is called a dividend. For every share of stock you own, you are entitled to the per-share dividend. For example, let’s say you own 10 shares of the XYZ Corp. And the XYZ Corp. pays a quarterly dividend of 25 cents. That means that four times a year you get 25 cents for each share you own. So over a year you would collect $1 for each share you own; in this case, your 10 shares would entitle you to a dividend payout of $10 a year. You are paid that dividend simply because you are a shareholder.

  Dividend yield is the per-share dividend divided by the share price of the stock. So let’s say you buy a share of the XYZ Corp. for $35 and the company pays a per-share annual dividend of $1. The $1 dividend divided by the $35 share price means your dividend yield is 2.86%. In fact, some solid companies have dividend yields of 3% to 5% or higher. Utility and telecommunication firms such as ConEd and Verizon were yielding 5% or more in early 2011. By way of comparison, a 10-year Treasury bond in early 2011 had a yield of about 3.5%. And remember, a 10-year bond maturity is way too long, in my opinion, given that when general rates rise, longer-term bonds will suffer the biggest price declines, and so if you hold on to that 10-year bond for the entire 10 years you have no chance of earning a higher yield. In other words, there is indeed “risk” in owning a 10-year Treasury. So what if you were to keep your money in a 1- or 2-year Treasury bill instead? Well, your yield in early 2011 was less than 1%.

  See why I think dividend stocks yielding 3% to 5% or more can be a smart part of your retirement portfolio?

  The Protection of a Stop-Loss Order

  For those of you who are interested in owning dividend-paying stocks but are also worried about downside volatility, I recommend you learn how to place a stop-loss order on an investment. With a stop-loss order, you instruct your discount brokerage to sell any stock once it hits your designated price. So, for example, if you bought an ETF at $35 a share but can’t bear the thought of your principal investment losing more than 15%, you could place a stop-loss order on your account that directs the brokerage to sell your shares if the ETF price falls to $29.75. But please know that in a volatile market there is no guarantee you will be cashed out at exactly $29.75. With a stop-loss order you are basically telling your brokerage to get you the best market price once it hits your target.

  HOW MUCH TO INVEST IN DIVIDEND-PAYING ETFS

  Here are my recommendations:

  • Determine how much of your portfolio you can comfortably devote to the stock market. I know I am repeating what I said above, but this is so important I want to make sure you hear me loud and clear: No stock investment, even an ETF portfolio of dividend payers, is to be mistaken for a cash investment, or a bond investment. You are to only invest money in dividend-paying ETFs that you will not need to tap for at least 10 years.

  • Diversify. There are two ways to invest in dividend-paying stocks. You can do it via ETFs that focus on dividend payers, or you can build your own portfolio of individual stocks that pay dividends. If you want to own individual stocks your portfolio should have a minimum of 10 to 12 stocks. It is never smart to have a larger portion of your retirement funds invested in one stock. No matter how stable that stock looks, we can never be sure of its future. If the money you want to devote to stocks is not enough to buy that many individual shares, then I recommend you focus on dividend-paying ETFs.

  HOW TO CHOOSE A DIVIDEND-FOCUSED EXCHANGE-TRADED FUND

  If you choose to invest in a diversified portfolio of stocks through an ETF, there are in fact many good options to choose from. ETFs tend to have lower expenses than many no-load mutual funds. And many broker
age firms are allowing you to buy and sell certain ETFs for free. As of late 2010, firms that were waiving their commission on certain ETFs included Fidelity, Schwab, TD Ameritrade, and Vanguard.

  ETF Fees: All ETFs, like mutual funds, have an expense ratio (the annual charge for administrative and management costs). It is expressed as a percentage. The average expense ratio for a stock mutual fund is about 1%, but some funds charge 1.5% or higher. Every penny that goes to pay the expense ratio is money you lose. And expenses are the one factor that is entirely within your control. You are the one who decides if you will pay high expenses or low expenses. In today’s world, where you want to earn as much as possible on your investments, focusing on minimizing the expenses you pay becomes crucial.

  Below are some ETFs you might consider for your portfolio. They all focus on dividend-paying stocks and have low expense ratios.

  TIPS FOR OWNING INDIVIDUAL DIVIDEND-PAYING STOCKS

  If you are interested in building a portfolio of individual dividend stocks rather than purchasing an ETF that holds a basket of dividend payers, make sure you follow a few key steps in putting together a strong portfolio:

  • Avoid the highest yielding stocks. As I write this in early 2011, the yield of the S&P 500 stock index, considered a solid benchmark of “the market,” is 1.8%. That average yield includes some firms that have lower yields and others with higher yields. For example, the utility and telecommunications sectors have mature companies that tend to offer higher dividend yields; the average payout right now for those two sectors is 4.3% for utilities and 5.5% for telecom stocks.

  Those are good benchmarks to keep in mind when investing in dividend stocks. When you see a dividend yield of 8%, 10%, or higher, that should be a big warning signal. When a stock yield is that high it is a sign that the company may be in trouble and unable to continue to make its dividend payout. It’s important to remember how a dividend yield is calculated: dividend/price. A $1 dividend on a $30 stock is a 3.3% yield. But let’s say that company runs into a big problem and its stock price falls to $10. Its yield is now 10% ($1/$10). Not because the dividend grew but because the stock price has taken a huge plunge. (Note: You will be averaging only 3.3% if you bought it at $30, but new investors will be getting 10%.)

  My recommendation is to avoid the highest-yielding stocks. Stick to solid blue-chip firms that have a long history of making dividend payments. They will typically yield anywhere from 2% to 6% or so, depending on their industry.

  Stock Tip: Standard & Poor’s maintains a Dividend Aristocrats index of firms that have managed to increase their dividend payouts for at least 25 years. It’s a good resource for anyone looking for investments to research. As of early 2011 the Aristocrats included:

  3M

  Aflac

  Abbott Laboratories

  Air Products & Chemicals, Inc.

  Archer Daniels Midland

  Automatic Data Processing

  Bard, C. R.

  Becton, Dickinson & Co.

  Bemis

  Brown-Forman

  CenturyLink

  Chubb

  Cincinnati Financial

  Cintas

  Clorox

  Coca-Cola

  Consolidated Edison

  Dover

  Emerson Electric

  Exxon Mobil

  Family Dollar Stores

  Grainger, W. W.

  Integrys Energy Group

  Johnson & Johnson

  Kimberly-Clark

  Leggett & Platt

  Lilly, Eli

  Lowe’s

  McDonald’s

  McGraw-Hill

  PepsiCo

  PitneyBowes

  PPG

  Procter & Gamble

  Sherwin-Williams

  Sigma-Aldrich

  Stanley Black & Decker

  Supervalu

  Target

  VF

  Walgreen

  Wal-Mart Stores

  • Diversify among different types of businesses. You want to build a portfolio that owns a mix of stocks that operate in different fields. For example, make sure you don’t own all energy stocks, or all consumer stocks.

  • Buy at the right time. There is one tricky aspect of investing in dividend stocks. Every company that pays a dividend chooses a date at which all shareholders as of that date will be entitled to the next dividend payout. For example, let’s say XYZ declares a dividend on September 15, with an ex-dividend date of October 15 and a payment date of October 31.

  The most important date to pay attention to is the ex-dividend date. This is the cutoff date for receiving the dividend; if you buy the stock on October 16 you will not be entitled to the dividend. The actual dividend payment will be made on October 31.

  You want to purchase your shares before an ex-dividend date to be eligible for the upcoming dividend. When you are considering selling shares of a dividend stock, if you wait until the ex-dividend date you can sell at any time between that date and the payment date and you will still receive the dividend. Just know that when it comes to buying and selling a dividend paying company, they reduce the price of the stock by the amount of the dividend so in the end it all comes out about the same.

  One of the sources that I use to pick good quality dividend stocks for my own portfolio is the newsletter published by Dividend.com. Founder Paul Rubillo writes a newsletter that is full of great information and is easy to understand. Not only does Paul offer tips on what to buy, but he also shares his insights on when a stock should be sold as well.

  WHERE TO FIND MORE INCOME

  Retirees in need of more income may want to consider a reverse mortgage. A detailed lesson on reverse mortgages is in the Home Class, but I ask that you carefully consider the often high costs and risks involved.

  No Free Lunch

  During your retirement years you may be invited to many luncheons where a financial advisor will present you with what he believes is the answer to your retirement needs. Please be careful. All too often, what is pitched to you as a great solution to your income shortage is in fact an inappropriate and expensive investment you should never make.

  My quick list of investments to avoid:

  A whole-life insurance policy

  A variable life insurance policy

  A variable annuity

  A universal life insurance policy

  A mutual fund that charges a load (sales commission)

  An immediate annuity (only as long as interest rates are low)

  LESSON 6. DOUBLE-CHECK YOUR BENEFICIARIES AND MUST-HAVE DOCUMENTS

  It may be years, if not decades, since you first opened your retirement accounts or purchased a life insurance policy. That is a long time for any number of life-changing events to have occurred. Marriage. Divorce. The death of a spouse. A remarriage. Children from a remarriage. Stepchildren. Grandchildren. Stepgrandchildren. A part of your legacy is to make sure you have updated your beneficiary statements to reflect your most current wishes. Please don’t leave this to memory. If you are not sure, go back and check.

  I also want you to pull out your must-have life documents and make sure they are also up to date. If you have any doubt as to whether you have all the documents you must have in my opinion, then please consult the Family Class, where I run them down in detail.

  The good news is that any estate planning—such as trusts—you have reviewed with your estate-planning attorney sometime in the past few years is likely in good shape. In late 2010 Congress voted in increases in the estate tax exemption. The current law, good through 2012, exempts the first $5 million ($10 million for married couples) from estate tax, and the tax rate on sums above that amount is 35%.

  LESSON RECAP

  Now that you have made it through this retirement class I hope you are feeling more confident about how you can best navigate what you and I both know are very challenging times for retirees. But as we discussed in “Stand in Your Truth,” sometimes the most powerful action we can take is to be wil
ling to change our perspective. Instead of becoming stuck in frustration and fear over what you have lost, or how much harder it has become, please stand in this truth: With the right perspective, I am confident you can make the necessary changes to keep your retirement dream alive and well.

  Recognize that even once you retire, you still have 20+ years that you need your money to last.

  Make sure that at the rate you are withdrawing money, your savings will last your lifetime; a 4% annual rate is a good rule of thumb.

  Protect yourself from a future in which interest rates will likely rise: Do not invest in long-term bonds or bond funds.

  Consider dividend-paying ETFs or stocks for a portion of your portfolio; many currently pay double the income yield of bonds.

  CLASS

  THE ULTIMATE LESSON

  I have a confession to make. The Money Class has been the most difficult book for me to write. For months I struggled to come to terms with just why I was having such a hard time with it, and that in itself was quite a jolt. After all, this is my tenth book; I wasn’t exactly suffering from a case of first-time jitters. Eventually what I realized is that I myself was having some trouble coming to terms with the very strong, sobering message of the book. I came to understand that I needed to dig deep before I could start to tell you how to dig deep.

  I want to share with you the process I went through in overcoming my personal roadblocks in writing this book. I offer this last lesson to you in the spirit of shared experience. I know that your journey has yet to begin; you end this book at a starting point. It’s now time for you to find the strength and resolve to put the lessons of The Money Class into action. It is my hope that in sharing the process I went through to bring this book to life I can provide added motivation for you.