Asking a financial advisor to name his favorite investment is like asking someone to tell you their favorite flavor of ice cream. We’ll say that every asset class (well, nearly every one) is wonderful in its own way, but we all have our own preferences.
The reality is, we all have asset types that we love more than the other Ben & Jerry’s flavors. For me, that asset class is stocks that pay steady dividends.
The main goal of investing is to maximize returns based on how much risk you are personally willing to take; to build the biggest possible nest egg. Dividend stocks can play a key role toward achieving that objective. Remember that your total return equals the growth in value of your holdings plus any income that your investments produce.
Most investors home in on just the growth piece of the equation, and give little thought to the income piece. But income is a crucial component to this equation, too. In fact, since 1929, dividends have accounted for 43 percent of the total S&P 500 return. As long as a dividend-paying company doesn’t hit a disastrous speed bump, chances are that they will continue to pay a measured level of income. They can also show varying degrees of price growth, depending on the sector and company.
Dividend stocks allow investors a modicum of control as their portfolio bounces over the sometimes turbulent market waves. There’s no surefire way to predict, much less control, market highs and lows and individual stock behaviors. But investing in dividend-paying stocks can give us a sense of predictability, thanks to the cash flow we receive from those shares. Of course, dividend payouts can change in a heartbeat if companies run into trouble. However, many corporations place an enormous amount of importance on maintaining and even increasing their dividend payout over time.
In fact, there are many businesses that have paid dividends for more than 100 years without interruption, like the York Water Co., Church & Dwight, and General Mills. In a world full of uncertainty, finding companies with historically steady payouts helps us sleep better at night.
Dividends can also be an indicator of a company’s financial health. As a wise money man once said, “Dividends don’t lie.” A company can recategorize expenses, adjust to complicated tax changes, and manufacture ways of favorably disclosing financial transactions. All of these practices can lead to “muddy” earnings reports.
When a company pays a dividend, it’s proving that it has cash in the bank, which typically indicates a strong and solid balance sheet fueled by a good business model that generates steady and growing profits.
Dividend stocks can also replace income that investors once received from the matured bonds they owned to provide their portfolios with both stability and interest income. The interest rates paid by bonds have been sliding for many years. In 2016, more than 32 percent of S&P 500 stocks had dividend yields greater than the 10-Year U.S. Treasury Yield. Hence, the cash flow we receive from stocks could outpace that of traditionally higher-paying bonds.
I’m a big fan of the 15/50 Stock Rule. If you believe that you have at least 15 more years of living to do, your portfolio should be comprised of 50 percent stocks and 50 percent bonds and cash. As long as you are an investor with at least a moderate risk tolerance, this is an option to strike a healthy risk/reward balance in your investment portfolio and replace some of your bond interest with stock dividends instead.
Interestingly, dividends have lost favor in recent years as firms opt instead for stock buybacks under the theory that these two methods of rewarding shareholders are essentially equivalent. Stock buybacks happen when a company repurchases its own shares of stock at market value, and then reabsorbs ownership that was previously distributed among public and private investors. This inherently helps a company to increase its earnings per share, as there are less shares outstanding; however, it removes a major incentive for income investors to own these stocks.
The most obvious perk of dividends is cash-in-hand — that quarterly income payment. Buybacks, meanwhile, can result in the market placing a higher value on the company’s shares. A buyback may cost you income but potentially give you growth in the form of a higher share price. As an income investor, I’d rather have the dividends.
Here’s the cherry on top of my l-love-dividends sundae: Most dividend income is taxed at a lower rate than ordinary income. This is because most dividends that come from U.S. companies fall into the “qualified” dividend camp.
For most taxpayers, these qualified dividends are taxed at 15 percent. Those who fall into the two lowest tax brackets will likely pay no tax on these dividends. For example, if you’re married filing jointly, your dividend income could be taxed at the 0 percent rate if your overall income is less than $75,900. On the other hand, those in the highest 39.6 percent tax bracket will be on the hook for 20 percent of the dividend payout. In most cases, these numbers beat the tax levels on “ordinary income.”
See why I love dividend stocks more than the others? While all the flavors might be good, there are some that will hit the sweet spot on a hot summer day.
Wes Moss has been the host of “Money Matters” on News 95.5 and AM 750 WSB in Atlanta for more than seven years now, and he does a live show from 9-11 a.m. Sundays. He is the chief investment strategist for Atlanta-based Capital Investment Advisors. For more information, go to wesmoss.com.
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