When you look at the dividends that stocks pay, you at first might wonder why anyone would care. Stocks considered good dividend payers might pay 1-2%, where you can get more than that easily in bonds, something on the order of 3-4%, without even heading into junk categories if you go into the longer term bonds. You can also get a 10-15% return by investing in stock mutual funds long-term. If you are a good stock picker and choose a few companies that grow rapidly, you can make returns in the range of 20% or more. (Don’t count on this – stock picking is difficult and things don’t always work out.) So why would anyone care about dividends?
The answer is that the amount of the dividend isn’t what matters. It is the growth rate. You may be buying a stock that is paying a 1% dividend today, but if that company raises the dividend by 15% per year, the dividend will double in a little less than five years. This means you’ll be making 2% on your original investment in about five years, 4% in about 9 years, and 8% in about 14 years. The price of the stock will increase as well, so the absolute dividend rate may stay at about 1%, but you’ll still be getting a higher rate on your original investment. You’ll just get more in return if you ever decide to sell the shares.
As an example, let’s look at Home Depot. If you bought 1000 shares of Home Depot back in the year 2000, you would have paid around $40,000 and collected a dividend of $160 for the year, or about 0.3%. Since that point the dividend has grown to the point where today those same 1000 shares would be paying about $2,360, or about 5.9% of your original investment. The price of Home Depot has also increased since that point, where your 1000 shares would be worth $136,000 today, so the dividend rate if you bought in today is about 2%. As the company has matured, it has been paying out a higher percentage in dividends since the company needs less of its money for growth, but it is still paying less than a bond would because there is also the growth component involved.
With a bond, you’ll get the same payment amount for the life of the bond, then you’ll probably get the same payment amount if you reinvest the money after the first set of bonds mature. In fact, a real issue with using only bonds in retirement is that the amount of income you’ll receive in numerical dollars will stay the same. You may retire and have a bond portfolio that pays $60,000 at age 65, which may take care of your needs easily. In 20 years at age 85, however, you’ll probably still be getting $60,000 from your bonds, but that amount of money will only buy half as much, so it will be like living on $30,000.
If instead you were to have a portfolio of dividend paying stocks that paid $60,000 when you first retired, if the companies raised their dividends by an average of 7% per year, they would be paying about $120,000 when you reach 75 and $240,000 when you reach 85. If things cost twice as much when you were 85, you would still be able to buy as much with $240,000 as you could have with $120,000 when you retired. The only issue is that since dividend paying stocks in growing companies – those that would be increasing their dividends regularly – might pay 1-2%, where bonds might pay 4-5%, so you would need to have two to three times as much money in a dividend-stock portfolio as you would have in a bond portfolio to produce the same income level.
If you are several years from retirement, you can buy stocks that are growing quickly and therefore pay no dividends now, but that will mature to the point where they may start paying dividends and growing those dividends in the future. For example, a few years ago, Apple paid no dividend at all (in fact, someone told me in a comment to a post I’d written about how future dividend potential causes a stock price to rise that they would never pay a dividend, about a week before they announced that they would start). Today, Apple pays a dividend of $2,28, or about 2%. If you get into one of these stocks early and hold it into retirement, they will automatically become dividend stocks to provide income for you through retirement.
So remember, when buying stocks for dividends, the potential future dividend is more important than the rate paid today. So pay attention to things like dividend growth rate and how much room the company has to expand.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.
