Dividends are one of the most fundamental concepts in investing, particularly when it comes to investing in retirement. Because they’re so basic, some advisors assume clients know how dividends work, including the role we hope they’ll play in your portfolio. However, I find it’s helpful to take some time to explain how dividends work and how we use them.
First off, we incorporate dividend stocks and dividend investing into all our client portfolios, but they are particularly relevant for retired clients. When you retire, the goal of your investments generally shifts from growth to income; instead of growing your nest egg, you’re thinking about how you’ll use that money as income to support you.
Income portfolios tend to be more conservative, and as the name suggests, they tend to focus on investments that generate income, including bonds and dividend stocks.
What are dividend stocks?
Let’s start with what dividends are. When publicly traded companies report a profit, they might reinvest those profits back into the company. However, they could also divvy up a portion of those profits amongst shareholders in the form of dividend payments. When you buy stock in a company that pays a dividend, you’re buying a dividend stock.
When we invest in dividend stocks, we’re looking for companies that consistently pay out dividends, and whose dividend payouts are increasing over time.
Think of it in terms of income: You don’t want to be paid the same salary for your whole life. In the same way, you don’t want to earn the same income throughout retirement, particularly as inflation may eat away at what that money can buy. Increasing dividend payments can help with that.
I often recommend clients think about dividend stocks like a rental property. When you’re buying a rental property, you’re concerned with the property itself and it’s great if the value increases. But you’d be just as concerned about the rent payments as the property itself. You’d look at whether the tenants pay on time, and whether the rent they pay is fair. Essentially that’s what we’re looking for when we search out dividend investments.
I also want to touch briefly on the type of companies that issue dividend stocks. Once upon a time, the most famous dividend-issuing companies were “blue chip” American firms — think big, industrial companies. While many people still have this image in their heads, it can be a bit outdated. These days, a large number of dividend-paying companies are based in Europe.
When we invest in dividend stocks, we often do so via funds. These funds specialize in dividend stocks and search the globe for companies that meet certain criteria for dividends and income generation. The goal of using funds is to help our clients access the best dividend-paying stocks, even if those companies aren’t commonly mentioned on the pages of the Wall Street Journal.
Dividend stocks and bonds
Many clients know intuitively that as they near retirement, their portfolios will shift more toward bonds, since fixed income investments are more focused on capital preservation and income generation. They may be less aware of the role dividend stocks play in a diverse, income-driven portfolio.
We’ve mentioned inflation a few times in this article so far, and that’s deliberate. It’s important to make sure that rising prices don’t hurt your ability to fund your lifestyle in retirement.
Bond investments can be particularly susceptible to inflation, since the income they pay out is both fixed and influenced by interest rates. In a low-interest rate environment (like the one we’re currently experiencing) bond yields tend to be relatively low. So, if inflation increases (which can also happen in a low-rate environment), there’s a risk that the income generated from bond investments may not keep pace with inflation. This is where dividend stocks may help.
Companies that issue dividends are still companies, and companies tend to thrive in low-rate environments. When rates are low, it’s cheaper for businesses to borrow money and invest in growth, improvements, and other measures that fuel profits. Profitable companies have an easier time paying out dividends to investors. Of course, companies won’t thrive just because rates are low, there are numerous other factors at play. But the overarching point is that dividend stocks react to low interest rates differently than fixed income investments like bonds. That diversity can help protect an income portfolio from inflation, and it’s one reason we make sure to include both in our clients’ retirement plans.
If you have questions about the role dividend investments play in your portfolio, we can discuss at our next meeting.
Dividend payments are not guaranteed and may be reduced or eliminated at any time by the company.