For an income investor, stocks are all about the dividends. Early in your investing career you can re-invest your dividends. Later, you can live off of the dividends without ever touching the principal.
IFO does not recommend automatic dividend reinvestment, the situation in which your broker or the company itself buys shares for you, even fractional shares, with each quarter’s dividend. We suppose it could work if you intend to hold the stock forever, but if you ever want or need to sell it, calculating the capital gain can be a total nightmare.
But let’s look at the dividends in our model portfolio index (MPI). Yahoo! doesn’t calculate dividends that IFO could find on the website (they may have done so years ago), but it’s easy enough to figure it out. First, sum the annual dividends, then multiply by 20 shares per company.
This produces a total annual income of $188.40 on an original investment of $5000 (rounding) for a yield of 3.8 percent per year. Recall that in 2012, banks were paying about 1 percent on savings accounts. Today, banks pay about 0.5 percent, and the MPI yields 1.8 percent per year. Hence, the MPI has paid about $471 over its lifetime.
If you had bought 2.5 yr certificates of deposit at a bank at 1% interest, you would have earned about $125. Here is your risk (it’s called interest rate risk), if bank interest rates go up, stock prices may decline to balance investment returns to savings deposit returns.
When IFO was wondering what to do when the stock market crashed in 2008-2009, she was frozen for several months. Buy? Sell? Ptui!!!
Finally, we arrived at this thought: blue chip stocks were paying about three times what a savings account was paying. The Fed was hanging on to its low interest policy for dear life, even in the face of no economic recovery. One must face reality. Not what MIGHT happen, but what IS happening right now.
She did need income. She happened to have a pile of cash derived from sale of house and car and furniture and derelict stocks she no longer had confidence in.
[Some of those stocks, by the way, were mutual funds which had declined in price almost exactly as much as the ordinary stocks. Thus her budding animosity toward mutual funds. We’ve said this before, but it bears repeating, “We can lose money on our own every bit as fast as a mutual fund does and we don’t have to pay a fee for the privilege!”]
So, she took the plunge and invested most of the cash (leaving copious amounts in her credit union’s highest interest paying account available for living expenses and emergencies) in… dividend paying stocks. It was a good decision.
Back to interest rate risk. Today, the stock market went down over fears that the Fed will start to raise bank interest rates. (It’s a long story about how this happens which we won’t go into now.) If that happens, stock prices may go down since yields are expected to meet the new higher bank returns.
The difference between dividend yield and bank interest is the amount of risk the stock market attributes to the company’s ability to make a profit and pay dividends. Blue chips have higher, but safer, yields than speculative stocks, which have either no dividends at all or very tiny ones, since investors expect (hope for) big profits and price rises.
The MPI had a mix of blue chip and slightly risky stocks, but you can see that the yield plunged as stock prices soared. The portfolio is an overall winner because of this balance.
Remember with your own portfolio, whether imaginary or real, you need to keep an eye on each and every holding. One of them may start to go south and you need to be ready to sell when necessary.