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, which means accumulating portfolio income that provides for your financial needs long after you've stopped working. We're not proposing a get-rich-quick plan. In fact, we're saying the best investments come with patience and common sense.
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 will provide 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.
Is that enough for you to live on?
An equity portfolio has its own set of risks: non-guaranteed dividends and economic risks. Suppose that instead of investing in a portfolio of bonds, as in the previous example, you invested 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.
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 of your portfolio into stocks and half into bonds has merit, and should be considered. As an investor grows older, his or her 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 or it will eat away earning power. (For specifics, see "Creating a Dividend Portfolio for Young Investors.")
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 OK. 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 then 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 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 Among 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; therefore, 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 Among 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 that it's not an industry-wide problem that hits all of 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. Also, 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 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. However, based on a purchase made that year at $11.20 per share and the 2006 dividend of $2.12, the yield that 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 (25 years) and Mergent's "Dividend Achievers" (10 years). The Value Line Investment Survey is also useful in identifying potential dividend stocks. Companies that have raised their dividends steadily over time tend to continue doing so in the future, assuming that 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 trying to find an insurance policy that protects you no matter what happens; it 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.