Interest rates are historically low. Granted, you can earn nearly 2% in a money market account, but that rate will decline if and when the Federal Reserve lowers interest rates. Longer-term bond rates are lower, with the 10-Year Treasury at 1.5%-ish. You might look at corporate bonds or a corporate bond fund: LQD, and investment-grade corporate bond fund, yields above 3%, so there is that option. However, the more common alternative to bonds for yield is stocks that pay dividends.
With interest rates on traditional debt instruments as low as they are, dividend stocks become more attractive. What you should look for when you look to invest in dividend stocks, in addition to the current yield (the annualized dividend divided by the current stock price) is the opportunity for a hedge against inflation. For instance, the current yield on SPY, the S&P 500 Index ETF, is about 1.8%. If SPY’s price over the next year rises by the rate of inflation, say 3%, when added to the dividend, that is a 4.8% total return for the year, which is much better than you get with a bond, a 1 year CD, or most other traditional savings havens.
Diversify Your Dividend Portfolio
Many dividend-paying stocks are clustered into relatively few sectors. For instance, utilities, real estate investment trusts, large oil companies, and some traditional industrial companies typically pay higher dividends, or at least higher than the average S&P 500 company’s dividend. You might, for instance, buy 4 large oil company stocks – Chevron, Exxon, Shell, and BP all yield from between 4% and 7% – and declare victory on investing in dividend stocks. The problem is, stocks in one particular sector such as large oil companies tend to trade in unison. In my example, if the price of oil declines, your portfolio is likely to decline, and your hedge against inflation will not work out as planned. If oil goes down too much, these companies might lower their dividends, although companies typically make a strong effort at least to maintain their current level of dividends.
Regarding portfolio diversification, the typical financial planner might default to recommending mutual funds or ETF’s because they are diversified portfolios of securities. However, with the case of dividends, although there are many dividend funds, I am not a big fan, and I think you can do better on your own by buying individual holdings, as long as you know what you are getting yourself into individually and collectively.
I recommend that you target a yield percentage and pick a diversified portfolio of stocks that collectively earn that percentage. For example, set a goal to earn a 4% yield on a portion of your portfolio. Then pick stocks that earn 4% on a weighted-average basis. Some will earn more, and some less. The key is to make sure your portfolio is diversified among sectors, which means you should have 10 or more – a finance professor will tell you that you need 30 to be diversified, but you will be pretty well diversified with 10. Other things to watch out for:
- Try to avoid stocks whose yields look too good to be true. There are stocks out there that yield 10% or more. Typically these are companies that are in trouble, so really high yields are a red flag.
- Try to avoid master limited partnerships, or MLP’s. If you screen for “stocks that yield more than 4%”, many of your results will be MLP’s. There is nothing wrong with owning an MLP, as it is just a different form of ownership with voting rights different from what you find with stocks. The problem with MLP’s is that tax reporting at the end of the year is complicated because you get a K1 instead of a 1099, which could cause you to delay filing your taxes. The trend now is that companies that were previously structured as an MLP are converting to C-Corporation ownership so as to present investors with a cleaner ownership structure.
Another way to help to put together a diversified dividend portfolio that accomplishes what you want is to contact me and engage my services as a financial planner. I would enjoy helping you achieve your goals!