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March 21, 2014

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I've been investing in dividend growth stocks in my brokerage account for a few years now. Can't do it with my 401K, so I'm not "all in". The dividend income from those stocks has been steadily rising, and I've been automatically reinvesting the dividends each quarter, though some folks like to let the dividends accumulate and reinvest them in whatever stock is next up on their list to buy at a good price, instead.
If you already have a brokerage account somewhere, you can build a stock screener that will show you dividend paying stocks with a certain percentage yield, or any other criteria you feel are appropriate - I'm sure the books you're reading will give you some ideas on that.
I've mostly focused my buying on the S&P dividend Aristocrats and Champions list, as those stocks have a history of rising dividends over long periods of time.

I think something that you should consider as another benefit is the tax rates that qualified dividends receive.
If you are in one of the highest tax brackets (33,35,39.6%), the related qualified dividend tax rate (15,15,20% respectively) is a real benefit to dividend investing. Something for you and others to consider in addition to what you noted.

I have been doing it with a small portion of my portfolio of years. Additionally, I write weekly covered calls on them and have a really good cash producing rate of return.

It's a zero sum game, which is why dividend investing (while fine), isn't some panacea or better way of investing.

A company that makes profits can do 2 basic things with those profits: (1) invest in the growth of the company (acquisitions, paying down debt, capital equipment, buying back stock, even hoarding cash), or (2) return profits to shareholders as dividends. (1) + (2) each years equals the profits.

In an efficient market, a profitable company that pays zero dividends will see the value of the stock of the company increase (since it's expanding/buying back stock to increase the value/making acquisitions/improving its financials by paying down debt, etc.) in EXACT PROPORTION to the value of what dividends would have been if they paid out everything in dividends.

Indeed, many argue (like Buffett with Berkshire Hathaway) that you're better off with NO dividends, as taxes on the corporation AND shareholders are greater with dividends than the long-term capital gains tax rate, and because presumably a company investing more of its profits in growing the company is doing something smarter for the company's bottom line than just paying out dividends.

Long story short: you're just as well-off investing in low-cost diversified index funds without regard to dividends, and just selling small portions of your holdings to create the equivalent of "dividend cash flow."

Chadnudj--

But things are different when you're looking at creating retirement income, correct?

You can create your own retirement income by selling shares. It would be better to sell shares to "create your own dividends" so that you can pay capital gains taxes, which will be especially beneficial if they are long term capital gains. Or even better sell shares that have no gains and not pay any taxes. Or sell a combination of shares that have gains and no gains. With dividends, the full amount will always be taxable.

You quoted authors in favor of dividend investing. I would suggest also taking a look at some authors who prefer a total-return approach to investing instead of a dividend approach. This could help you make a more informed decision when deciding if you want to start investing this way. One such blogger you could look up is Larry Swedroe who has written several articles in the past couple months related to dividend investing.

The only stocks we buy are dividend payers. In fact, we avoided Apple for years because they didn't pay a dividend. The best outcome is when you get a dividend payer that has great growth as well which is what happened when we bought Lockheed. It is currently up 70% from when we bought it and those dividends roll into our account every quarter.

Stocks / mutual funds for growth, physical real estate for income. We keep it simple.

I agree with Chadnudj. @FMF the benefits you list are much more about the mechanics of cash flow rather than investment performance. I certainly see the benefits of a knowm revenue stream but this can easily be achieved with planned sales.

Why overweight dividend paying stocks in your overall portfolio? I am not at retirement but I'd suggest a total stock market fund which will pay dividends and then create a selling strategy to fund your income needs.

I disagree as selling shares reduces your entire principal portfolio amount, and dividend investors who finally reach a certain level only use dividend revenue without selling any shares. The difference is a dividend investor can die and leave the entire portfolio to heirs, and the person selling shares of non-dividend stocks will leave heirs less shares than they originally purchased.

Secondily: Dividend Companies raise dividends yearly and a company paying 3% in today's prices can be paying you 6% in 10 years if you held it, because of your initial costs basis.

I am building my dividend portfolio as well as part of my retirement income portfolio. This is in addition to my pension, executive deferred compensation and 401k (invested in Vanguard Index funds). Like FMF, I look at social security as gravy. The other described pieces above give me diversity of income streams at retirement and can provide support in case something does not go as planned. I can also avoid selling shares during down markets by using the dividend income and pension income as the primary sources.

I agree with Chadnudj. Dividend stocks are not better or worse. Always choose the best investment from all choices available.

Regarding retirement income- that gets more complicated. I am partial to the Modern Retirement Theory line of thinking. Google it-- if you have time-- its quite interesting. In a nutshell it advocates having different funds for different purposes. It starts with a "floor" of guaranteed fixed income (think social security, fixed annuity or pensions etc) to cover your lifetime basic "needs" (shelter, medical, food). This takes away the longevity risk associated with retiring as your basic needs are covered for life.

Then a very conservatively invested sum for emergencies or "contingencies"( think T-bills).

Above that you have a balanced portfolio (maybe 60/40) for the discretionary items you desire (trips, etc).

If there is money left over at the end it will be legacy money for giving or inheritance.

@EL selling shares doesn't reduce your total portfolio amount if you measure the amount of your portfolio in dollars. You should look at it as the total dollar value and not the quantity of shares owned. When a company pays a dividend the share price is reduced by the EXACT same amount, so if you reinvest the shares you will net out to the same amount of money invested in the company. When the company pays a dividend, yes the investor now has more shares, but the shares are now worth less.

@M#19 says it well. There is no magic in dividend stocks.

I would guess that inflation and interest rates could have a big impact on dividend paying stocks. The gap between interest rates and dividend yield makes these stocks either more or less attractive.

Over-weighting dividend stocks adds unnecessary risk to your portfolio.

@Stephen: since when does a company's share price reduce by the amount of the dividend? The market may choose to discount a stock's price the day it goes ex-dividend, but usually rebounds the next day. The market may also not do that. There is no mechanic in place that demands that a stocks price declines by the exact amount of the dividend. Therefore, one does not "net out" and the shares of stock are not worth less. If what you said was true, nobody would want dividend paying stocks.

I like dividend payers and have them in my 401k. No taxes, no worries, .... as yet!

@Chadnudj: A few months back I submitted a post about whether to pay off the mortgage or invest, given our circumstances. Thanks! I had been thinking along those lines and with your greater attention to the details, I am following your sugestions, they're working and I sleep at night!

We retired in 1992 and are very happy with the way things have turned out for us.

We have four income sources.
1) Our Social Security accounts for 6.5%.
2) Our pensions account for 9.8%.
3) Our IRA tax deferred income accounts for 40.5%
4) Our Trust account with federally tax exempt municipal bonds accounts for 43.2%.

We have zero stock investments.

The volatility of our investments is very low indeed, the income is highly dependable, and we don't have the headaches and expenses of keeping up rental properties as do some of our friends.

I never anticipated that our taxes would be high during our retirement but once you are 70 1/2 and forced to make mandatory required taxable distributions from your IRAs they take a big jump. Our IRAs soared between 1/1998 and 3/2000 because of the DOT.COM bubble and the 366% jump in the Nasdaq 100 index. Fortunately I got out within the 4 days after the top rather than riding it back down.

One comment I will make - take a look at a dividend paying stock the day after they go ex-dividend. A very simple thing happens; the next day's opening value is adjusted to take into account the reduction of equity attributed to the cash distribution. Dividends are priced into the market so you get the same benefits of selling without transaction costs. Then of course there is the tax impact; ordinary vs capital gains. Do some research on writing out of the money covered calls. You get the cash flow with a deferred tax benefit; they reduce your basis. I have some stocks with that I bought at 50 with 10 of tax basis. Sure, any cash received on writing a covered called in excess of tax basis are deemed capital gains, short term, but still. I bought MSFT at 23, wrote out of the money weekly covered calls over a 3 or 4 year period, and have basis of about 5 a share. Got 18 per share, excluding dividends, over the course of a few years, excluding dividends. Sure, it exposes you to additional risk if the price increases in the next week in excess of the strick price, but if you are selective in what you write, such risk can easily be managed.

Plus it provides some excitement to my otherwise unexciting portfolio.

Dividend Irrelevance Theory

Much like their work on the capital-structure irrelevance proposition, Modigliani and Miller also theorized that, with no taxes or bankruptcy costs, dividend policy is also irrelevant. This is known as the "dividend-irrelevance theory", indicating that there is no effect from dividends on a company's capital structure or stock price.

MM's dividend-irrelevance theory says that investors can affect their return on a stock regardless of the stock's dividend. For example, suppose, from an investor's perspective, that a company's dividend is too big. That investor could then buy more stock with the dividend that is over the investor's expectations. Likewise, if, from an investor's perspective, a company's dividend is too small, an investor could sell some of the company's stock to replicate the cash flow he or she expected. As such, the dividend is irrelevant to investors, meaning investors care little about a company's dividend policy since they can simulate their own.

I don't understand how any of you can possibly argue against dividend investing considering half of the historical returns from the stock market is from dividends.

As far as retirement income, I agree with using guaranteed income (social security, pension, annuities) to fund the basic necessities is the correct strategy. To fund discretionary expenses, consider a 30-35% equity income, 45-50% fixed income (traditional corp. bond, muni, etc.), and 10-20% alternative income (REIT, MLP, Option strategies, etc.) Always have some cash on the table and perhaps someday CDs will pay 4-5% again.

@Biere
Admittedly the interest rates on new CDs from banks are pretty low, however in July 2013 I had no problem buying taxable corporate bonds for my IRA issued by J.P. Morgan/Chase, maturing in 2036, with coupons ranging between 5.85% and 6.25%. I bought them in the secondary market on Fidelity Investments website.

The last of my CDs mature on 10/15/2015 and they are yielding 5.15% and were issued by Goldman Sachs Bank. During the recent great recession I had high yielding CDs at various banks and always kept the maximum amount per bank just below the FDIC insurance limit of $250,000. Sure enough several of the banks failed but the FDIC came through and gave me back my money, plus accrued interest in every case.

I might recommend what is probably the best book on the subject: "The Single Best Investment" (check amazon). Also, Jeremy Siegel goes to great length to discuss the superior performance of dividend payers in his book "The Future For Investors". Both books are highly recommended. Frankly, I think the idea of selling off shares in retirement is a flawed strategy. A retiree who can simply take his growing dividend without selling shares is in a far better position to ignore the variables of the stock market and just get on with life. The retiree who is banking on the "total return" approach with no regard to dividends often finds himself constantly watching the market knowing that much of his paper profits can be wiped out in a heartbeat. Then to dial down the risk, they load up on bonds! Sometimes up to half the portfolio or more! The same bonds that are generating negative real rates of return! And then they throw stones at the dividend investor who simply lives off his portfolio's growing income without having to load up on short term bonds that pay nearly nothing! Give the dividend income approach a careful look in retirement. It's a superior method at generating retirement income and it passes the "sleep well at night" test. FWIW,

What Chadnudj said. Since dividends and long-term capital gains are currently taxed at the same rate, I don't even think there will be (generally) a tax advantage.

The "40% of returns were dividends" is something of an optical illusion. If the dividend-paying companies *hadn't* paid dividends through that time period, then there would have been the *same* returns, only 100% accounted for by rise in their stock prices. Dividend-paying doesn't magically create company value; it simply shifts cash from the stock price to the dividend paid.

Now, this is in pure economic theory. Reality is surely messier and more complicated. And dividend paying may be a proxy for a *type* of company you find desirable--older and more conservative, generally. (Indeed I would be interested to see if dividend-paying doesn't ultimately portend a period of decline, since apparently the company can think of no better use for its money than to return it to shareholders.) But there are probably more accurate ways to identify those.

As for relying on dividends in retirement, unless you are in preferred stock (which is a whole different kettle of fish, and really more like debt than equity), dividend payments are *in no way ever guaranteed*. If the stock market crashes, or individual companies get into trouble, you are faced with drops in dividend-based income as well. I don't see how relying on an income source which could go to zero in a crisis provides any better sleep than other approaches.

I think the key is a balanced portfolio, some of which might include dividend paying stocks. There's also the simplicity factor....if you are looking for streams of income, dividend stocks can be simple - you have the dividends be a stream of income without having to worry about selling and possibly rebalancing. I'm surprised that no one mentioned income based mutual funds which mainly invest in dividend paying stocks. That could be another simpler way to get this type of investment methodology into your portfolio.

Bottom line - it depends on your risk tolerance, your income needs and how simple you wish to make the mechanics of your portfolio.

FMF,

I've been investing in three dividend stocks using Loyal3 as my broker. I like loyal3 because it lets you get into buying equity with no transaction fees.

The stocks are: Microsoft, Coca-Cola and Disney.

One thing your post did not mention, but would be good to better illustrate, is the need to control costs when you invest. Transaction fees can take a large portion of your returns if you are not careful and can retard the amount of cash you have available to invest.

@JB,

Of course the stock price must be reduced (through market mechanisms) to account for the dividend. It is not exact and other factors are obviously involved including the general short term trend of the market, but long term the stock has to reflect the value of all the company assets including cash. If cash is distributed the loss of that value to the company must be reflected in the value of the stock over time. This can be seen more easily during special large dividends.

On Nov 15, 2004, Microsoft paid a one time special dividend of $3 per share.

The stock closed the day before at right about $30. It opened on the 15th at just above $27. As soon as the dividend is paid the company is worth less than it was the day before. Usually a dividend is a few cents so its very hard to distinguish any reduction from market noise but it is there. If the market didn't reflect that it would be completely irrational rather than just partially irrational such that traders who aren't even very savvy could get rich by buying stocks the day before a dividend and selling them the day or two after. Of course that doesn't work because the price reflects the dividend after it is paid.

FMF- chadnudj above hits on the age old argument of total return investing vs. dividend investing. Go to seeking alpha, and in their search engine plug in "magic pants" and look for authors "early retiree" (total return camp) and "chuck carnevale" (dividend camp). Some of these articles have over 200+ comments, so it is a decent discussion. It is a solid discussion, even if you consider SA a "pump and dump" stock website.
Different routes with the same goal: a secure worry free retirement.

JC and Gran Torino --

Thanks for the suggestions. I will check out those books/site.

Of course you can make a case that investing in capital gains is better than investing in dividends, and vice versa.

There is nothing whatever wrong with dividend investing. Here are some of the advantages. Most ordinary people are not stock market wizzards. They want a system that is easy to understand and easy to operate, and is good enough. Dividends have several advantages over capital gains. Once you are paid your dividend, the money is yours. The market can collapse, and you still have your dividend. The share price can lose a huge amount of its value, and the dividend still arrives in your mailbox bang on time. For most retail investors, who haven't got the time to spend stockwatching, or looking over their shoulders in case stocks fall in price, wiping out their paper profits, dividend investing is much more practical.

If the retail investors are then leaving their dividends in deposit accounts, the value of that money begins diminishing immediately.

Just FYI, a number of the major banks in the U.S. were actually legally prohibited from paying out dividends from ca. 2008 to 2011 (too lazy to look up exact dates). Even now, they need to pass "stress tests" and get permission from the Fed to do so. If you were relying on JPM dividends for monthly income in that difficult period...tough noogies for you.

My investing approach is basically dividend-indifferent (as it's almost all index funds), but these arguments advanced in favor of focusing on dividend investing are causing me near-physical pain.

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