At Premier Financial Group, our retirement investment advisors often field questions about dividends. Should these payouts be the center of a retirement plan?
It's easy to understand why so many investors are interested in dividends. After all, as of August, 2015, more than 40 percent of the S&P 500's total return came from dividends. But while dividends once served as a major source of income for many retirees — along with pensions, interest from bonds and social security distributions —today, things are a bit different.
Here's what you need to know about the role of dividends in your retirement plan.
How do Dividends Fit Into Your Wealth Strategies?
First, a dividend primer: Some companies, often well-established corporations, pay their stockholders on a regular basis. These payouts, typically made each quarter, are known as dividends. Dividend amounts aren't based on stock prices, so many investors view them as a steady, safe source of income. Dividends can also be reinvested, thus benefitting the investor with compounding. However, there's no guarantee that dividends will continue, as companies can stop payouts at will.
While dividends can be seen as a potential source of income during retirement, many retirement plan advisors don't recommend that dividends should be central to a retirement planning strategy or the main consideration when buying stocks. Why? Because though many established companies pay dividents, market declines can affect prices. When companies pay out dividends, it's common for the stock price to decrease proportionately. If an investor chooses not to reinvest, the price drop means that the principle value of their account drops, too. When your principle value drops, you increase the risk of reducing your long-term gains.
Instead of focusing on dividends, it's essential for investors to take a total return approach. As far as wealth strategies go, that involves taking stock of your retirement goals, your time horizon, your income sources, and your risk tolerance. Then investors can create a diversified portfolio that spreads risk across asset classes.
Dividend Yield and Strategic Wealth Planning
As a general rule, long-term growth potential and dividend yield are inversely related; in other words, the higher the divident yield, the lower the potential for long-term growth — and if you've got a decade or more before you retire, it's important to be aware of this relationship.
The answer lies in treating dividends as just one part of a diversified, balanced portfolio that's more focused on total return than high dividend yield. Not only does chasing yield decrease potential for long-term growth, it also may increase risk when interest rates increase. Instead, meet with your retirement planning advisor and work together to create a portfolio that includes assets from multiple classes. This spreads risk, so you can ride out volatility and inflation.
By focusing on total return rather than dividends, your portfolio will contain asset classes that respond differently to different market conditions. This decreases your risk exposure and helps mitigate volatility.