People have a wide range of investment options when it comes to saving for retirement, from exchange-traded funds (ETFs) to annuities. One investment that you may not have considered for retirement is dividend-paying stocks.
While not all stocks pay dividends, some will provide a regular payout to shareholders. These dividends are a share of the company’s profits. You can invest in dividend-paying stocks both before and during retirement. While still saving for retirement, these dividends can be reinvested to purchase more shares and boost savings even more. During retirement, dividends can provide some additional income to be used for monthly expenses. These dividends may continue for the remainder of your life, which is what makes them a valuable tool.
The Potential Benefits of Investing in Dividend Stocks
One of the biggest benefits of dividend stocks is that they also tend to be value stocks, which means that they may be safer, or less volatile than non-dividend paying stocks. Companies that have a steady enough income stream to pay dividends are not likely to go out of business in the near future. A value stock often has a relatively low price compared to the income of the company and the dividend that it pays. You should look for companies that have paid at least 20 years of reliable, or increasing dividends to its shareholders.
Another thing to consider is that yield on bonds has been quite low since the 2008 recession. Bonds that protect against inflation have actually had negative yields in recent years. Dividend paying stocks currently can produce higher cash flow than bonds; for example, currently, adjusted for inflation, the real yield of 10-year Treasury bonds is -0.95 percent.
In general, dividend stocks perform better in times of heavy inflation, so they can be a good choice if you are worried about the impact of inflation on your retirement savings. The companies that pay dividends often make more money during times of inflation, so they often end up paying higher dividends to investors.
You may also see tax benefits from dividend stocks. While some dividends are classified as ordinary income, others will get taxed at the capital gains rate, which can be considerably lower than your overall income tax rate. Do some research to figure out which companies pay which sort of dividends. Also, it is possible to invest in mutual funds and ETFs that focus on dividend stocks. Dividend yields on these funds average about 3 percent and can be as high as 9 percent.
The Drawbacks of Dividend Stocks
Of course, dividend stocks do have some risk involved. As with any individual stock, the risk is higher than with bonds. Even value stocks have some risk involved. For many years, General Electric was a blue-chip stock, but it is now worth only a fraction of what it was even a decade ago due to unfavorable economic conditions, and has reduced its dividend to a few pennies per share. Stock dividends are never guaranteed, so you should always be prepared for the risk involved with stocks if you choose to invest in them, even if they do currently pay dividends. The fate of an individual company is virtually impossible to predict, and even professional stock analysts make mistakes. Investments with lower risks, such as Treasury bonds, have much lower returns, so they will limit the profitability of a portfolio. However, they can also help mitigate the risk of individual stocks. Another option is to invest in mutual funds and ETFs, which help build diversification.
A related problem is that diversification can be difficult with dividend stocks. Most dividend stocks are in energy, financial services, and consumer goods, which are fairly narrow buckets. You may struggle to get an adequate amount of diversification to mitigate portfolio risk. However, you can also diversify with investments outside of dividend stocks provided they are not a central part of your retirement income. You can also opt for mutual funds and ETFs, but it is important to figure out how diversified they are considering the fairly limited scope of dividend paying stocks. At any rate, asset allocation can become extremely tricky, and since it is impossible to predict how dividends will change over time, you may want to work closely with a financial advisor to ensure you have a good overall strategy.
The Bottom Line When It Comes to Dividend Stocks
Investing in dividend stocks can provide a boost to your investment portfolio, but these options do come with risks, especially if you concentrate heavily on them. When part of a balanced portfolio, they can provide a steady stream of income, but it is important not to rely on them too much or accept undue risk for dividend payments. Just as with any type of investment, holding only dividend stocks puts you at substantial risk, and dividend paying stocks can fall a lot in a market crash, especially if the company cuts or eliminates the dividend. Before investing in dividend stocks, you should do your homework on the company’s history and its likelihood to continue paying dividends.