This is a guest contribution from Ben Reynolds at Sure Dividend. Sure Dividend uses The 8 Rules of Dividend Investing to systematically build high quality dividend growth portfolios.
Sean at One Smart Dollar recently laid out 3 scary facts about social security cuts in retirement:
- The social security fund is expected to be depleted around 2033
- Once the fund runs dry it can (in theory) only pay out what is being currently paid in
- This means retirees will only receive about 75% of promised benefits
To put it plainly, this is not good.
The politics of social security are beyond the scope of this article. Instead, this article focuses on what to do about it.
What To Do About Potential Social Security Benefits
You can put your head in the sand and hope that social security benefits do not decline, or you can take action.
There is a specific type of investment that is uniquely suited to retirement (and preparing for retirement) portfolios.
This investment class is dividend growth stocks. The name might sound like an oxymoron to you – after all, dividend stocks have historically (and wrongly) been associated with slow growth.
Before we get into the facts about dividend growth stocks, lets review why they are good retirement investment vehicles.
Retirees need current income. Moreover, they need income raises that (at least) match inflation – if not outpace it.
Dividend growth stocks provide current income (they are dividend stocks, after all). They also provide income raises over time through dividend growth.
Not all dividend growth stocks are a good match for retirees. The truth is, some are riskier than others. In addition to current income and growth, retirees also need safety and stability.
Some dividend growth stocks offer safety and stability, and some don’t. We will cover where to find safer (on average) dividend growth stocks further on in this article.
But first, it’s important to clear up misconceptions about dividend investing with several facts.
The Facts about Dividend Growth Investing
It may surprise you that dividend paying stocks have historically outperformed the market over long periods of time.
I believe this is because dividend stocks by definition are able to return money to shareholders. This means they are (in general) profitable – and have money left over to give to shareholders.
Dividend growth stocks have historically performed even better than dividend stocks in general. Dividend growth stocks are shares in businesses that are able to pay rising dividend income over time.
Not only do these businesses (in general) create positive cash flows, these cash flows grow over time. Some of the most recognizable businesses in the world are dividend growth stocks, including:
- Coca-Cola (KO)
- Wal-Mart (WMT)
- ExxonMobil (XOM)
All of the businesses above are Dividend Aristocrats – stocks with 25+ years of consecutive dividend increases.
Remember when I said we’d cover were to find the safest (highest quality) dividend growth stocks? The Dividend Aristocrats Index is the perfect place to quickly find high quality dividend growth stocks.
Think about what it takes for a business to pay rising dividend income 25 (or more) consecutive years in a row. For a business to do this it must have a strong and durable competitive advantage.
“Our approach is very much profiting from lack of change rather than from change.”
– Warren Buffett
This increases the safety of the underlying business. Don’t confuse the underlying business with the stock price. The stock price of all businesses bounce around. During recessions, you can expect dividend growth stock prices to decline just like any other business…
But their dividends will likely continue rising. Wal-Mart is a great example. The company’s earnings-per-share and dividends grew through the Great Recession of 2007 to 2009 – it didn’t impact business results at all.
Dividend investors tend to find it easier to hold onto shares of great businesses by watching dividend income roll in instead of paying attention to stock prices.
“Do you know the one thing that gives me pleasure? It’s to see my dividends coming in.”
– John D. Rockefeller
Yes, Rockefeller went a bit overboard with how much he liked his dividends (the only thing that gives him pleasure? Ouch), but the point remains: watching dividends instead of stock prices leads to less panic selling – and therefore greater returns.
How To Build Your Dividend Growth Retirement Portfolio
The easiest way to add dividend growth stocks to your retirement portfolio is to invest in a high quality dividend growth ETF. My 3 top choices are below:
- First Trust Value Line Dividend Income (FVD)
- Vanguard Dividend Appreciation ETF (VIG)
- S&P 500 Dividend Aristocrats ETF (NOBL)
There are pros and cons to investing in dividend stocks versus dividend ETFS. A full analysis is beyond the scope of this article. In short, ETFs save time and are better for those who don’t enjoy researching stocks. For those who do, individual stocks can be better as they are more cost effective (no management fee) and provide greater flexibility.
As mentioned previously, the Dividend Aristocrats Index is an excellent place to look for high quality dividend growth stocks that have proven themselves by increasing dividends over a long period of time.
But great businesses don’t make great investments at any price… Valuation matters.
A wise strategy is to invest in Dividend Aristocrats that have:
- A lower price-to-earnings ratio than the S&P 500
- Equal or greater growth prospects than the S&P 500
- A higher dividend yield than the S&P 500
Following this strategy will result in investing in high quality businesses with shareholder friendly managements trading at fair or better prices.
“Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”
– Warren Buffett
Beyond this, it’s important to invest for the long run. High quality businesses can compound your wealth over time – if you let them. This means holding them regardless of what the stock price does (as long as the underlying business is sound).
Finally, don’t put all your eggs in one basket. A portfolio of around 20+ individual stocks will provide sufficient diversification from ‘getting it wrong’ with any one holding. There is a tradeoff between the number of stocks in a portfolio; more stocks means better diversification, but less concentration into your best ideas.
Dividend growth investing is not a ‘one size fits all’ approach. You can select higher yielding dividend growth stocks if you have a greater need for current income, or lower yielding dividend growth stocks with greater expected growth rates if your retirement date is further off. Regardless, dividend growth investing makes a compelling choice for those in retirement or preparing for retirement because it provides growing income over time.
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