In a world in which central banks openly admit a desire to influence prices in a way that causes life to become more expensive for everyone, investments with a high likelihood of growing payouts are absolutely worth considering. This is especially true for the “buy-and-hold-forever” type of investor. But whether you end up putting money into a dividend-growth opportunity depends on a variety of factors. One such factor that I suspect is often overlooked is age. Depending on your age, it may make sense to forgo a dividend-growth opportunity in favor of a higher-yielding fixed-income security.
A “buy-and-hold-forever” type of investor who hopes to fund his or her retirement using income streams built up from decades of dividend growth should keep in mind that the older one gets, the shorter one’s time frame gets. When you are in your 20s, 30s, and 40s, there is still plenty of time for many dividend-growth stocks to eventually grow the dividend by a sufficient amount that the opportunity cost of forgoing a fixed-income opportunity is worth it over the long run. As you progress through your 50s, however, the situation begins to change.
Currently, there are many popular dividend-growth companies yielding under 3%. Several examples include Exxon Mobil (XOM), The Coca-Cola Company (KO), PepsiCo (PEP), Johnson & Johnson (JNJ), Wal-Mart Stores (WMT), 3M (MMM), Colgate-Palmolive (CL), International Business Machines (IBM), and Walgreen (WAG). These are companies that many would view as stable and worth owning as “buy-and-hold-forever” stocks. But if your purpose for owning shares of the aforementioned companies is to benefit from a rising income stream over time, the starting yields of under 3% will require a very long time frame before the total income earned begins to outpace what one could earn from various fixed-income opportunities.
The same thing is true for broader-market indices. The S&P 500 (SPY) is currently yielding less than 2%, and the Dow Jones Industrial Average (DIA) isn’t much better. It is quite possible that many thousands of investors are, at this time, actively considering putting new money to work in one or more of the companies or indices I just mentioned. If you are one of those investors, your primary goal is income, and you are approaching retirement or in retirement, the table that follows will likely be of interest:
In the table below, I show how much income would be generated over a 25-year period by a $50,000 investment that started with a 3% yield and experienced compounded dividend-growth of 6% per year. The 6% dividend-growth figure is, in my opinion, a fair number to use for this hypothetical example.
What type of fixed-income yield would it take to make the income-focused dividend investor consider a fixed-income alternative? Let’s examine how much income would be generated over a 25-year period by a $50,000 investment that had a fixed yield of 6.50%.
It is only in year 25 that the dividend-growth investor would finally catch up and surpass the amount of income collected by the fixed-income investor over the same time period. And as the next table demonstrates, even at a fixed rate of just 5.50%, it is only in year 20 that the 3% yield compounded at 6% annually begins to generate more total income.
At a fixed rate of 4.50%, it would take 14 years for the hypothetical dividend-growth example to being generating more total income. And at a fixed rate of 7.50%, it is only in year 29 that the 3% yield compounded at 6% annually begins to generate more total income.
Some readers may be quick to point out that 6% compounded dividends over a multi-decade time frame would imply a rising share price. I agree. But the “buy-and-hold-forever” investor who plans to live off the income stream rather than realize capital gains should consider this: Do you want to potentially collect less income in your lifetime and take on the risks of investing at the bottom of the capital structure simply so that your beneficiaries might one day receive a larger bequest. It is also worth pointing out that during the years in which the fixed-income investor is collecting more income than the dividend-growth investor, the extra income could be reinvested. This would generate even more future income for the fixed-rate investor and extend the time period during which the fixed-rate investor has an income advantage.
Other readers might wish to point out that finding fixed yields high enough to make it worth forgoing a dividend-growth opportunity is not possible in today’s interest-rate environment. I would counter by saying that throughout the Fed’s zero-interest-rate policy, it has been entirely possible to build a high-yielding portfolio of fixed-income securities with reasonable levels of credit risk. I have done so myself. It takes time to build such an allocation. Some months offer more opportunities than others. But just as equity-focused investors exercise patience, so too should someone looking to build his or her ideal fixed-income allocation.
There are countless scenarios I could outline using various yields and dividend-growth projections. I encourage you to run scenarios that are the most applicable to your circumstances, all the while remembering that in addition to starting yields and dividend-growth rates, your age at the time of your initial investment should play a role in your decision-making process.
More from The Financial Lexicon:
The 5 Fundamentals of Building a Retirement Portfolio
Options Strategies Every Investor Should Know