In investing, knowledge is power. To paraphrase Ben Graham's investment advice, you should strive to know what you are doing and why. If you don't understand the game, don't play it. Stay away until you do.
If you are considering building a portfolio for income, this article will help guide you toward success. This means accumulating portfolio income that provides for your financial needs long after you stop working. This isn't a a get-rich-quick scheme, though. In fact, we're saying the best investments come with patience and common sense.
- Inflation and market risk are two of the main risks that must be weighed against each other in investing.
- Dividends are very popular among investors because they provide steady income and are a safe investment.
- Investors should do their homework on potential companies and wait until the price is right.
- As you build, you should diversify your holdings to include 25 to 30 stocks, and five to seven industries.
The Scourge of Inflation
Inflation and market risk are two of the main risks that must be weighed against each other in investing. Investors are always subjecting themselves to both, in varying amounts depending on their portfolio's asset mix. This is at the heart of the dilemma faced by income investors: Finding income without excessive risk.
At 5% interest, a $1 million bond portfolio provides an investor with a $50,000 annual income stream and will protect the investor from market risk. In 12 years, however, the investor will only have about $35,000 of buying power in today's dollars assuming a 3% inflation rate. Add in a 30% tax rate, and that $50,000 of pre-tax and pre-inflation adjusted income turns into just under $25,000.
The question is: Is that enough for you to live on?
The Basics of Dividends
Dividends are very popular among investors, especially those who want a steady stream of income from their investments. Some companies choose to share their profits with shareholders. These distributions are called dividends. The amount, method, and time of the dividend payment are determined by the company's board of directors. They are generally issued in cash or in additional shares of the company. Dividends can be made even if a company doesn't make a profit, and do so to keep their record of making regular payments to shareholders. Most companies that pay dividends do so on a monthly, quarterly, or annual basis.
Dividends come in two different forms—regular and special. Regular dividends are the ones that are paid out at the regular intervals. Companies pay these dividends, knowing they will be able to maintain them or, eventually, increase them. Regular dividends are the distributions that are paid out through the company's earnings. Special dividends, on the other hand, are paid out after certain milestones, and are normally a one-time occurrence. Companies may choose to reward their shareholders with these payments if they surpass earnings expectations or sell off a business unit.
Many investors choose to include dividend-paying stocks in their portfolios for a number of reasons. First, they provide investors with regular income monthly, quarterly, or annually. Secondly, they offer a sense of safety. Stock prices are subject to volatility—whether that's company or industry-specific news or factors that affect the overall economy—so investors want to be sure they have some stability as well. Many companies that pay dividends already have an established track record of profits and profit-sharing.
An equity portfolio has its own set of risks: Non-guaranteed dividends and economic risks. Suppose instead of investing in a portfolio of bonds, as in the previous example, you invest in healthy dividend-paying equities with a 4% yield. These equities should grow their dividend payout at least 3% annually, which would cover the inflation rate, and would likely grow at 5% annually through those same 12 years.
Equity portfolios come with risks involving non-guaranteed dividends and economic risks.
If the latter happened, the $50,000-income stream would grow to almost $90,000 annually. In today's dollars that same $90,000 would be worth around $62,000, at the same 3% inflation rate. After the 15% tax on dividends—also not guaranteed in the future—that $62,000 would be worth about $53,000 in today's dollars. That's more than double the return provided by our interest-bearing portfolio of certificate of deposits and bonds.
A portfolio that combines the two methods has both the ability to withstand inflation and the ability to withstand market fluctuations. The time-tested method of putting half your portfolio into stocks and half into bonds has merit, and should be considered. As an investor grows older, the time horizon shortens and the need to beat inflation diminishes. For retirees, a heavier bond weighting is acceptable, but for a younger investor with another 30 or 40 years before retirement, inflation risk must be confronted. If that's not done, it will eat away earning power.
A great income portfolio—or any portfolio for that matter—takes time to build. Therefore, unless you find stocks at the bottom of a bear market, there is probably only a handful of worthy income stocks to buy at any given time. If it takes five years of shopping to find these winners, that's okay. So what's better than having your retirement paid for with dividends from a blue chip stock with great dividend yields? Owning 10 of those companies or, even better, owning 30 blue-chip companies with high dividend yields!
Motto: Safety First
Remember how your mom told you to look both ways before crossing the street? The same principle applies here: The easiest time to avoid risk in investing is before you start.
Before you even start buying into investments, set your criteria. Next, do your homework on potential companies and wait until the price is right. If in doubt, wait some more. More trouble has been avoided in this world by saying "no" than by diving right in. Wait until you find nice blue chips with bulletproof balance sheets yielding 4 to 5%, or even more. Not all risks can be avoided, but you can certainly avoid the unnecessary ones if you choose your investments with care.
Also, beware of the yield trap. Like the value trap, the high yield trap looks good at first. Usually, you see companies with high current yields, but little in the way of fundamental health. Although these companies can tempt investors, they don't provide the stability of income that you should be seeking. A 10% current yield might look good now, but it could leave you in grave danger of a dividend cut.
Setting Up Your Portfolio
Here are the six steps to guide you in setting up your portfolio:
1. Diversify your holdings to at least 25 to 30 good stocks. Remember, you are investing for your future income needs, not trying to turn your money into King Solomon's fortune. Bearing this in mind, leave the ultra-focused portfolio stuff to the guys who eat and breathe their stocks. Receiving dividends should be a main focus, not just growth. You don't need to take company risk, so don't.
2. Diversify your weighting to include five to seven industries. Having 10 oil companies looks nice, unless oil falls to $10 a barrel. Dividend stability and growth is the main priority, so you'll want to avoid a dividend cut. If your dividends do get cut, make sure it's not an industry-wide problem that hits all your holdings at once.
3. Choose financial stability over growth. Having both is best, but if in doubt, having more financial wherewithal is better than having more growth in your portfolio. This can be measured by a company's credit ratings. The Value Line Investment Survey ranks all of its stocks in the Value Line Index from A++ to a D. Focus on the "As" for the least amount of risk.
5. Find companies with a long history of raising the dividend. Bank of America's dividend yield was only 4.2% in early 1995 when it paid out $0.47 per share. Based on a purchase made that year at $11.20 per share and the 2006 dividend of $2.12, the yield an investor would have earned for that year based on the stock's original purchase price would be 18.9% in 2006! That's how it's supposed to work. Good places to start looking for portfolio candidates that have increased their dividends every year are the S&P "Dividend Aristocrats" list and Mergent's "Dividend Achievers." The Value Line Investment Survey is also useful to identify potential dividend stocks. Companies that raise their dividends steadily over time tend to continue doing so in the future, assuming the business continues to be healthy.
6. Reinvest the dividends. If you start investing for income well in advance of when you need the money, reinvest the dividend. This one action can add a surprising amount of growth to your portfolio with minimal effort.
The Bottom Line
While not perfect, the dividend approach gives us a greater opportunity to beat inflation, over time, than a bond-only portfolio. If you have both, that is best. The investor who expects a safe 5% return without any risk is asking for the impossible. It's similar to looking for an insurance policy that protects you no matter what happens—it just doesn't exist. Even hiding cash in the mattress won't work due to low, but constant, inflation. Investors have to take risk whether they like it or not, because the risk of inflation is already here, and growth is the only way to beat it.