Planners may also face a dual threat caused by increased longevity and the potential for higher than average long-term inflation. In addition, traditional retirement income sources, including pensions and Social Security, may not be sufficient. All these factors may increase the burden on portfolios to produce more income, at a time when yields from income producing investments are at the lowest levels in 50 years.
Advisors facing the daunting task of trying to help retirement-bound investors should consider structuring retirement portfolios by increasing allocations of dividend-paying equities. Structuring portfolios in this manner enables portfolios to capture the higher returns offered through a combination of dividends and price appreciation. Dividend-paying stocks can offer retired investors the advantage of providing two sources of inflation-fighting protection: first, from price appreciation (which can increase capital balances) and the second, and perhaps more important, from rising dividend income streams as companies periodically increase dividend payments to shareholders.
Since the technology bubble burst in 2000, the return from price appreciation has been disappointingly flat. On the other hand, dividend trends over this period have been surprisingly positive through several recessions and a major financial crisis. Over the past 10 years, companies in the Dow Jones Industrial Average Index (DJIA) have increased dividends by 76%, companies in the S&P 500 have increased dividends by 68%, and those on the NASDAQ Index drove up dividends by 490%. The rise in NASDAQ dividends has been driven in part by a dramatic growth in the number of technology companies that have adopted dividend payout programs. For the first time in history, the technology sector has become the second largest dividend-paying sector in the United States.
Accelerating dividends may be good news for income hungry investors and a powerful ally in their fight against inflation. Consumer Price Index (CPI) increases have averaged approximately 2.5% per year since 2000, while dividend increases on the popular indexes have outpaced the increase in CPI better than 2:1.
We seem to be in a positive cycle, whereby companies are providing fast-paced dividend increases to make their stocks more attractive to aging investors. Since 1987, dividend payout ratios have averaged 47% for the DJIA and 37% for S&P 500 companies. Today's payouts of 32% and 26% respectively seem rather modest and may indicate that companies have plenty of earnings capacity to continue increasing dividends.
Dividends can also provide a source of return that pays investors while they wait patiently for price appreciation and bull market conditions to return to equity markets. Historically, between 40% to 50% of the return that investors associate with investing in stocks has come from dividends, with the balance being earned through price appreciation.
Traditional beliefs that non-dividend-paying growth stocks provide persistently higher returns than dividend-paying stocks may need to be discarded in the face of contradicting statistical evidence. The combination of return from dividends, when combined with price appreciation, has allowed DJIA stocks to outperform the NASDAQ stocks by more than 2% per year on average since 2000.
For retirement-bound investors who need to accumulate capital, dividend reinvesting can unleash compounding and dollar cost averaging. Compounding builds shares by reinvesting dividends to buy more shares each quarter. As the number of shares increase, so does the dividend payment, which drives individual share balance higher. Dollar cost averaging is the practice of systematically investing money (reinvested dividends) usually monthly or quarterly, over a long period of time. Systematic investing leads to lowering the average purchase price of shares as stock prices fluctuate. When share prices are lower, you can purchase more shares.
Since 2000, many investors have become risk averse after experiencing several large bear market declines. They have been reluctant to expose their remaining capital to further losses by investing in equities. In order to acquire price appreciation, these fearful advisory clients need a process that attempts to mitigate market volatility and large losses so they can stay invested. It's a very human problem. Human survival instincts are genetically hard wired to spur investors to get out when the market drops, which is a central issue as to why investors can lose when using the "buy-and-hold" approach to investing. Instead of hanging on during tough market conditions, their fear can lead them to sell out their positions. What some advisors have been missing is a focus on dividend-paying stocks combined with a responsive methodology that is designed to conserve capital when the risk of capital loss increases in down market cycles. Now is the time for advisors and investors to reconsider conventional "buy-and-hold" growth stock approaches.