Dividend Stocks – Is it the answer?

Dividend stocks are fantastic for older investors who want to generate lower taxed income (only 15% capital gain or even at 0% $19,500 a year in 2012) with potentially lower risk. If you think we are heading into a bear market (which might every well be 2018 because Greek is at risk off defaulting, and will pull out of the European, they might want to get their currency back to better control of their economy as both of the parties are against austerity measure outlined by the EU), losing less with dividend stocks is a good strategy if you want to stay allocated in equities. Rebalancing out of equities may be an even better strategy. I use 40 as the number for younger because Americans are living longer, life expectancy went from 60 back in the day, to 80, 90, or even 100 years old. So, 40 is the new 30. I’m a pro at diversifying. However, it’s very hard to pick a winner. You can read further on  how you don’t have to pay a single penny on taxes from capital gain or dividend income here.

Here are some arguments against dividend stock for younger than 40 years old investors.

1. Dividend yields relatively low at 2-3% you need a lot of capital to generate any sort of meaningful income. Even if you have a $500,000 dividend stock portfolio yielding 3% that’s only $15,000 a year. Remember, the safest withdrawal rate in retirement does not touch principal. Furthermore, you must ask yourself whether such yields are worth the investment risk.

2. Not Aggressive Enough if You are Younger Than 40 – invest the majority of your equity exposure in dividend yielding stocks is a sub-optimal investment strategy. By the time you’re ready for retirement, you’ve missed out the big chunk of growth. Dividend stocks will provide over 100% returns if you give them a long enough amount of time. When things turn sour, everything turns sour so there had better be more than a 2-4% dividend yield and some underperforming appreciation to compensate.

3. Reach Growth Plateau – Company start paying dividend is because management cannot find better growth opportunities within its own company to invest its retained earnings. Hence, management returns excess earnings to shareholders in the form of dividends or share buybacks. If a company pays a dividend equivalent to a 3% yield, management is essentially telling investors they can’t find better investments within the company that will return greater than 3%. Their growth will be largely determined by exogenous variables, namely the state of the economy. You can see the case with Microsoft and Apple start paying dividend and offer share buy back, when the market of Window and iPhone in the US start growing at 5-8% instead of doubling every year from 2003.

1/29/15 Microsoft drop ~9% after drop in revenue due to businesses has moved to cloud computing.

4. Inherent Risk of Rising Interest Rate – We are now at 12 month highs and a 50% bounce from the bottom. If you believe interest rates are slowly going to rise as the Federal Reserve starts tapering off its quantitative easing, dividend yielding stocks and REITs will significantly underperform the broader stock market. Dividend stocks and REITs act much like bonds in this scenario.

How rising interest rates negatively affect the principal portion of a dividend yielding asset just think about real estate. If 30-year mortgage interest rates suddenly climb from 4% to 6%, there is going to be a serious slowdown in demand for new homes because of affordability reasons. As a result, home appreciation will slow or even decline to get back to supply/demand equilibrium. The same thing will happen to your dividend stocks, but in a much swifter fashion like you see below with Realty Income’s 20% correction over one week. Realty Income is down 2% June 2016 vs. 0.95% for the S&P 500 when QA come to an end.

Of course there are always tactical opportunities in oversold situations. If interest rates ease off a bit, all these REITs that are getting blow to bits will have a nice bounce. (Since June 2013 the stock has gotten back up from $37 to $58). Who know when you catch a falling knife?

5. Build a large amount of Net Worth First, then slowly doing the switch as you get older. Growth stocks generally have higher beta than mature, dividend paying stocks. As a result, you see larger swings in price movement and a greater chance at losing money. But for someone in their 20s, 30s, and even 40s it’s better to go a little further out on the risk curve for more return because you’ve got more time to make up for any losses.

In a bear market, low volatile, dividend stocks will outperform as investors seek income and shelter. We are not in a bear market yet, but who knows for sure. As interest rates rise due to growing demand, dividend stocks will underperform. They may even get slaughtered depending on what you invest in. You’ve gotten to decide how defensive and offensive you want to be.

6. Diversifying – Don’t put your eggs in one basket! The best way to go is having multiple income streams or diversifying in different places.  In the second half of our lives is to have roughly a 30%, 30%, 30%, 10% split between stocks, bonds, real estate, and risk free investments like CDs. If you follow such a net worth split, then you already have a healthy amount of assets that are paying you income.

If you decide not to diversify your net worth and go all into dividend stocks, it’s possible to replicate such income, but it will be hard. You’ll also be in for some sleepless nights when the markets turn. The gross rental yield on my main rental property is 10%. Subtract all property taxes and operating costs, the net rental yield is around 8%

That’s why you should be a Well Rounded Investor. Diversifying in Everything, including Cash position. It’s like having an extra layer of insurance to protect your nest egg. You’d sleep better at night, and don’t worry about stock losing 1000 points over 2 weeks period, because your bond, your investment property is still earning money for you. It will take a lot more for the US to go through what we went through in 2008-2011 again.