CHICAGO — Managing money was much easier in your parents’ and grandparents’ time than it is today. A generation or two ago, people lucky enough to accumulate a few dollars for investment had a minimum of easy rules to follow.
By dividing their money among a few blue-chip stocks and some AAA-rated bonds, they could sit back and turn their attention to other matters. It isn’t that easy these days.
The last few decades have seen some startling changes in what used to be reasonably stable rules for money management. After years of relatively calm interest rates, the 1970s ushered in a period of skyrocketing increases. By 1981, yields on 10-year Treasury bonds peaked at an unheard 15.8%.
Between 1984 and 1995, long-term Treasury earnings averaged more than 13%. Financial life was a comparative breeze in those days.
Since then, Federal Reserve Chairman Paul Volcker and his successors have gone to work determined to push interest rates down—and they’ve succeeded. As of the time of this writing, the yield on a 10-year Treasury bond hit a 40-year low of 1.83%.
As you might expect, rapidly falling interest rates made high-yielding stocks more attractive to investors, driving prices up. But Treasury bonds and low-dividend growth stocks benefited even more during that time. From 1995 to 2000, growth stocks were by far the best choice for investors.
Now, with interest rates hovering at anemic levels, stocks that pay healthy dividends are getting more attention from many perceptive investors than fixed-income securities, or low-dividend growth stocks.
There’s good reason for this shift in attention. With the current 15% tax rate on dividends, overall yields on solid dividend-paying stocks are among the most attractive investments available today. With the expectation of reasonable growth in earnings, these stocks stand to put more money in your pocket than growth stocks or bonds.
With the top tax rate of 15% on dividends vs. a top rate of 39.6% on interest income, a stock paying a dividend of 3.0% will give you a better return after taxes than a bond paying 4.5%.
Then, there’s the question of safety. Traditionally, bonds have been considered safer than equity investments, but that may not be true in today’s financial environment. There is hardly any place for interest rates to go but up in the intermediate term, and perhaps into the distant future. When interest rates rise, bond prices go down. Further, the principal amount of a bond remains fixed. Even at today’s low inflation rates, the purchasing power of the principal in any fixed-income investment erodes over time. At today’s inflation rate, the purchasing power of the principal in a 30-year bond will be reduced by half at maturity. If inflation rises, as it most surely will, that 50% drop in purchasing power would come much sooner.
With dividend-paying stocks, you enjoy your regular payout along with the likelihood of price growth over time.
This is not to say that there is no place for bonds in your portfolio. Depending on your age and financial circumstances, some portion of your investments in fixed-income securities makes sense. Most financial experts, however, recommend that equities, especially stocks with a long record of dividend increases, should make up the largest portion of your asset allocation.
Generally, I make it a policy not to recommend specific stocks or funds, but you’ll have no trouble locating the dependable dividend payers in the stock listings in the business section of your local paper or on the Internet.
There is a nice choice of blue-chips paying dividends from 2% to better than 4%. Even those stocks paying between 1% and 2% shouldn’t be ignored. A solid company with a long record of uninterrupted dividends will probably raise its dividend as earnings grow. For a list of stocks that have raised dividends every year for at least 25 years, visit dividend.com.
I hope I’ve made the case for high-dividend stocks in your investment portfolio. The numbers, I believe, speak for themselves. However, none of this is to suggest that I’ve changed my oft-repeated mantra that small investors should not attempt to pick individual stocks. For the reasons that I’ve outlined in the past, mutual funds are a wiser choice for most people. Unless you have a great deal of time, a penchant for analyzing voluminous statistical data, plus a lot of luck, you’re better off leaving the buying decisions to the people who spend their full time battling the tides of the volatile financial waters. That’s why no-load mutual funds should be a part of your life.
Should you decide to hop on the income stock bandwagon, there is a long list of mutual funds out there—such as the Vanguard Dividend Growth Fund and the T. Rowe Price Dividend Growth Fund—that concentrate on high-quality companies that pay good dividends. These funds, like their many counterparts in other fund families, are widely diversified. Thus, their yields will be less than the top-yielding individual stocks. Still, over the long term, they should give respectable returns.
But keep this in mind: When you’re searching for the fund that will suit your personal needs best, look for no-load funds with solid track records and low management fees. In my view, the larger, better-known fund families will be your safest choice.
Information in this article is provided for educational and reference purposes only. It is not intended to provide specific advice or individual recommendations.