Sufficient yield, keeping up with inflation, and outliving the funds available are three major concerns facing investors when building a retirement portfolio. A high dividend yield equity portfolio provides a competitive approach for addressing each of these concerns. Such a portfolio produces higher income per dollar invested, growing income and principle over time, higher total returns, lower volatility, and a much reduced risk of outliving retirement savings. I will address each of these favorable characteristics individually.
Higher Income per Dollar Invested
A high dividend yield equity portfolio can produce 2 to 3 times the income per dollar invested in comparison to a traditional low risk bond portfolio. This means a much smaller portion of your portfolio has to be dedicated to income generation. For example, $1 mil portfolio invested in 10 year Treasury Bonds generates, at current interest rates, about $26,000 annually. On the other hand, the same amount invested in an equity dividend portfolio yielding 6.5%1 generates $65,000 annually, or 2.5 times the T-bond portfolio. In addition, dividend income grows over time while bond income remains the same, an issue I will discuss next.
Dividend Growth Keeps up with Inflation
Unlike the income produced by fixed income securities, equity dividends grow at a rate likely to exceed the inflation rate. Not only do you start with more income per dollar invested, but the dividend income stream will likely provide an inflation hedge.
Most companies pursue a policy of growing dividends over time, however every once in a while a company reduces its dividends. Researchers have found that companies increase dividends 60% of the time, keep them unchanged 36% of the time, and reduce them only 4% of the time. 2 That is, increasing/unchanging dividends outnumber decreasing dividends by 27 to 1. An equity dividend portfolio will thus provide a growing income stream for investors.
High Dividend Growth and Yield mean High Total Returns
Research shows that the higher the dividend growth rate and the higher the dividend yield, the higher is the total portfolio return. At the overall market level, research reveals that higher cash payout and dividend yields lead to higher future market returns.3 More specifically, this research reveals that dividend yield is a good predictor of future earnings growth, so a period of rising dividend yield bodes well for future market returns.
This belies the common belief that executives increase dividend payout when investment and future growth opportunities are poor. On the contrary, company management, by increasing the dividend payout, is actually signaling higher future cash flows, which in turn foretell higher stock returns.
At the individual stock level, too, dividend payout and yield are predictive of future earnings growth and future returns.4Among other things, this body of research has found that dividend changes contain information about 1) future earnings that cannot be found in other market data, 2) company profitability, and 3) future positive earnings surprises. Other research has found that companies experiencing financial distress rely more heavily on dividends for communicating with investors.
The overall conclusion is that rising dividends signal improved company performance and, in turn, higher individual stock returns. The market myth that higher yielding stocks produce lower total portfolio returns is soundly rejected by the evidence.
Higher Returns, Lower Volatility
In order to appreciate the power of dividends, consider the average annual compound returns for S&P 500 stocks over the period 1973 through 2010, which are reported in Figure 1 below. Over this period, S&P 500 stocks that paid growing dividends outperformed dividend-cutting S&P 500 stocks by an astonishing 10% annually. Growing dividends are predictive of strong future stock returns, while zero or reduced dividends are a predictor of poor stock returns.
Even more surprising, volatility declines as dividends increase. Figure 2 below reports the annual standard deviation for the four portfolios reported in Figure 1. In general, volatility decreases as dividends – and accompanying stock returns – increase. In particular, the dividend-growing portfolio experiences roughly a third less volatility than does the dividend-cutting portfolio.
And Principle Grows Too!
Not only do dividends grow over time, but so does the principle, even if all dividends are paid out and not reinvested. As we saw in the last section, the higher yield, the higher the return. For, example, with a dividend yield of 6.5%, we would expect principle growth of greater than 3%, based on an average annual stock market return of 10%.5This means that both dividends and principle, without dividend reinvestment, would be expected to grow at or above the long-term inflation rate of 3% annually.
You can “have your cake and eat it to” with both growing income and principle. A high dividend yield portfolio is more beneficial compared to a traditional low risk bond portfolio on dividend yield and growth as well as on principle growth. Does it get any better than this?
The Chance of Outliving Your Funds is Dramatically Reduced
Since both dividends and principle grow over time, on any future date you will likely be receiving more income and be sitting on a larger principle. That is, with a high yield portfolio, you will grow wealthier over time, assuming you do not withdraw principle, which you should not have to do since dividends grow over time. This is in contrast to a fixed income portfolio in which the best you can hope for is a level income stream and the same principle over time.
Adding Global Exposure with Dividend Stocks
Adding dividend paying stocks from outside the U.S. substantially increases selection options and also adds global diversification to a portfolio. Many U.S. investors have a home country bias that inhibits them from considering opportunities with companies not domiciled in their own country. This prejudice can limit investors’ participation in the larger opportunity set of foreign-based companies. Research shows that U.S. investors are under-allocated to international stocks by as much as 50%. While non-U.S. Companies make up 50% of the world’s market cap based on the MSCI All Country World Index they collectively represent just 27% of U.S. investor assets.6 As such, by only investing in U.S.-based companies, U.S. investors are potentially missing out on important dividend income opportunities.