The time has come to consider income investments. Yes, those boring bond and stock funds that provide interest and income in a market I believe will at best do nothing throughout most of next year. Granted, you won’t be the center of attention at your holiday office party but you will be way ahead of the game when it comes to preserving your wealth and earning a decent rate of return.
Before you skip to the next article hear me out. If you had invested $1,000 in a group of high yielding dividend stocks in 1957 by 2007 you would have garnered $640,877, according to Jeremy Siegel in his book “Stocks for the Long Run”. If instead you had bought low-paying dividend stocks with that same money and held them during the same time frame you would still be ahead but your $1,000 would have only netted you $96,591. That’s right; the high dividend group outperformed the low yielding stocks by $544,286.
Now that I have your attention consider this: last year, according to Standard & Poor’s, dividend paying stocks returned over 18% compared to non-dividend paying returns of 13.7% while high-flying NASDAQ stocks only returned 8%. Overall, between 1926 and 2007, dividends contributed a whopping 42.12% of the total return of the benchmark S&P 500.
From a tax perspective, dividends are also attractive. There was a time when dividends were taxed at your individual income tax rate. Today that rate has dropped to 15% and if you are in a low income bracket as little as 5%. Of course, the new administration under Barak Obama may decide to increase that rate but he could just as easily keep it the same while raising the capital gains rate instead.
You also have a choice on whether to reinvest your dividends or take them in cash. That will largely depend on your age and circumstances. Those who are retired or close to it may want or need the income while those with 30 years of investing ahead of them may opt for dividend reinvestment. In declining markets like we have had this year, taking the cash has also proven to be a good strategy at least in the short term.
Reinvesting dividends is as easy as checking a box on your portfolio account form and there are no commission fees for that service. There is also a Dividend Re-Investment Plan (DRIP) which many companies offer. It allows you to purchase additional shares of their stock directly at no extra cost.
Reinvesting dividends can also make a difference in your overall returns. Over a 10- year period a $10,000 investment in the S&P 500 Index with all dividends reinvested would have netted you $17,753 (versus $15,131 without the dividends). Over thirty years the difference is staggering: an investor would have earned $154,401 (without dividend reinvesting) but $386,252 with all dividends reinvested as of the end of 2007.
In today’s markets an investor has a large number of dividend bearing stocks to choose from. But buyers beware. Next year is going to be hard on companies and many dividends will be cut. What looks like a fabulous yield now may end up in smoke. Take financial companies for example. The banking sector traditionally pays a healthy dividend but the prospects for continued tough times ahead thanks to the credit crisis makes that industry’s ability to maintain dividends a gamble at best.
One rule of thumb that works fairly well is to pick companies where earnings are at least twice the dividend payout. Another tip is to avoid certain cyclical stocks, those companies that do better in high growth economies but perform poorly in slow or recessionary environments. These companies tend to cut their dividends when times get hard. Finally, firms that have a track record of constantly raising their dividends are strong bets for long term investors but even they can falter so be careful and do your homework.
I have found that investing in income mutual funds is an easier and safer way to invest than trying my luck with individual stocks especially in highly volatile environments like we face to day. It is easier to let the mutual fund manager and his analysts pick 50 to 100 companies based on earnings and industries. That way if one or two companies end up cutting their dividends there will be plenty more that can continue to provide a stream of income. Of course income funds will go down with the stock market but at a lesser rate. Since the stock market has already had a substantial correction and no one can really call the bottom, income funds make sense for the conservative investor who is invested in cash and wants to put a toe back in the markets.
Today I have found almost a dozen income funds that are yielding north of 7% and in some cases 12% or more. Given that your typical money market fund is yielding around 2% while long-term Government Treasury bonds are offering less than three, that’s not a bad deal for those who are willing to take on some additional risk.