Why Dividends Matter
With interest rates starting to rise, some investors are considering pulling money out of dividend paying investments (i.e. stocks) and investing in interest generating investments (i.e. bonds). There are a number of informal “rules” in this area, including comparing the 10 year US Treasury rate (currently about 3.08%) and the dividend rate on the S&P 500 (currently about 1.72%) and investing in the higher returning securities.
The return on equity investments is through appreciation and dividends (if paid). Companies are not legally obligated to pay a dividend to stockholders. Warren Buffett’s Berkshire Hathaway does not pay a dividend, for example. Buffett rewards his stockholders strictly through price appreciation although, ironically, if you read Buffett’s letters to his stockholders, the performance of the company’s various investments are all measured by their current or potential cash flow.
In the meantime, the price of equities can vary all over the place (a.k.a. volatility) as the market goes through its various cycles and gyrations but generally drifts higher.
The return on fixed income investments is through periodic interest payments and the return of principal at the maturity of the security. The certainty of the interest income stream and the certainty of the return of principal are the attractive characteristics of the fixed income investments. As interest rates change, the price of the bond, which is the value at today’s interest rate of the two cash flow streams (periodic interest and face value at maturity), will change, but at maturity, the principal is returned. This tends to dampen the price swings in fixed income securities as interest rates change because, in the end, the investor will simply get back their principal.
In the meantime, the purchasing power value of fixed income securities will decline with inflation.
So what is the best strategy?
There is no best strategy except in hindsight. There is a trade off in virtually everything in investing. Nothing in investing is as black and white as it may seem when looking strictly at the numbers.
As I manage funds for retirement whose length of time is unknown, I have to be concerned that the client does not outlive the value of their portfolio. That means that equities which appreciate, must be a part of the portfolio. The longer the expected retirement period, the higher will be the percentage of equity in the portfolio for this purpose.
At the same time, since equities are volatile (capable of significant changes in price, including zero), there is a parallel investment in fixed income, which provides for steady interest income and the return of the face value of the fixed income security at maturity.
The interest returned on the fixed income securities is used to pay both the investment management fee on the account and to buy equities to offset the decline in purchasing power of the fixed income securities.
In the financial planning world, the mix of equities to fixed income securities is generally accepted to be around 60% equities to 40% fixed income to provide the client with a long term stable portfolio capable of supporting a thirty year or so retirement horizon. In the current rising equity market, some of my portfolios are approaching 70% equities. When portfolios get much above 70% equities, I begin to buy additional fixed income securities with the dividend and interest income, as well as any additional contributions to the account, to bring the portfolio back into the desired balance.
So dividends and equities matter in the portfolio. Dividends allow the purchase of additional equities or fixed income securities to maintain the equity/fixed income balance. It is how future inflation is hedged.
I went downstairs and asked Riley, my Golden Retriever, what she thought of the dual strategy of equities and fixed income to balance and to build retirement accounts. She was lying on her left side. I outlined the dual strategy to her. She raised her head, looked at me and then raised her right front paw signaling that I should give her a tummy rub. After a few minutes, she rolled over and lifted her left front paw indicating that I should continue the tummy rub but on the other side. Good advice Riley – you need both equities and fixed income for a balanced portfolio just like a good tummy rub is done on both sides.
All the best.