Here’s what we cover in this episode:
📈 Dividend stocks vs. bonds: what really protects against inflation?
⚠️ The danger of chasing yield (and what Westinghouse taught us)
🏦 How dividends impact taxes in taxable vs. retirement accounts
🧰 Our holistic approach to income planning
🔄 Rebalancing 101: how selling high and buying low protects your future
Executive Summary:
Many individuals approaching retirement seek a steady stream of income insulated from stock market volatility. To achieve this, they often focus on dividend-paying stocks. While dividend investing is intuitively appealing (“I just live off my dividend income!”), a holistic and diversified approach to retirement income is often more robust and less risky.
The Allure of Dividend Investing
The primary appeal of dividend investing is generating an income stream without drawing down principal. This provides a sense of security. Dividend investors may feel less impacted by market downturns as long as their dividend income remains stable. Since many dividend-paying stocks are mature businesses earning healthy profits, the day-to-day volatility of dividend stock prices tends to be moderate or low. Unlike fixed interest bonds, many dividend-paying stocks increase their dividends over time as their earnings grow, providing some inflation protection. Any reinvested dividends will compound over time, contributing to long-term wealth accumulation.
The Downsides and Risks of Dividend Investing
Despite its perceived advantages, a narrow focus on dividend income comes with significant risks and downsides.
Opportunity Cost: Companies paying high dividends may be reinvesting less in their own growth, potentially leading to missed opportunities for capital appreciation available in other companies or sectors.
Tax Inefficiency: Dividends received in taxable accounts are taxed each year, creating “tax drag” that can significantly reduce after-tax returns. Capital appreciation is only taxed when stocks are sold. Additionally, capital gains on long-term holdings are taxed at lower rates than dividends.
Yield Chasing and Dividend Traps: Chasing high dividend yields can be dangerous. An exceptionally high yield often signals something is wrong with the company. Dividend yield is calculated by dividing the dividends paid by the stock price. A severely depressed stock price (low denominator) can artificially inflate the dividend yield even if the dividend payout (numerator) has not increased. In these situations, a seemingly attractive yield actually indicates the dividend may be unsustainable. Such situations are “dividend traps.” Unsustainable dividends can be reduced or cut completely. Worse yet, a struggling company with an unsustainable dividend may go bankrupt, wiping out a significant portion of an investor’s net worth.
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Dividend Yield (Payout Ratio) = Dividend Per Share ($)/ Price Per Share ($)
Example 1:
Dividend Per Share = $5
Price Per Share = $50
Dividend Yield = 10%
$5/$50 = .10 * 100% = 10%
Example 2:
Dividend Per Share = $5
Price Per Share = $25
Dividend Yield = 20%
$5/$25 = .20 * 100% = 20%
Notice the dividend yield doubled, yet the dividend paid in both examples did not change. The share price declined by 50% from Example 1 to Example 2, which is the sole reason the dividend yield doubled. This is the definition of a dividend trap.
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Concentration Risk (Lack of Diversification): Focusing heavily on dividend stocks can lead to an undiversified portfolio concentrated in specific industries (e.g., utilities, certain communications companies, consumer staples, pharmaceuticals). Concentration in a small number of stocks or sectors can lead to losses if those companies or sectors fall out of favor. This is a particularly serious risk for portfolios consisting of only a handful of dividend-payers. Many once-dominant companies that paid attractive dividends eventually struggled or went bankrupt, saddling undiversified investors with significant losses.
Inflation Vulnerability: While some quality dividend-paying companies may grow their dividends with inflation, many high dividend-paying stocks do not increase their payouts much and are more susceptible to dividend decreases, making them less effective as an inflation hedge.
Wyze’s Holistic Approach to Income Replacement
A more holistic approach to retirement income involves a diversified portfolio combining different asset classes (e.g. stocks, bonds, cash) with distinct characteristics and roles within a portfolio.
Stocks: The stock portion of a balanced portfolio provides potential for capital appreciation and growing dividends. This is the “engine” powering the portfolio.
Bonds: Addsstability and income, which is especially important in bear market downturns. A well-diversified bond portfolio can provide significant income with less risk than even “safe” dividend paying stocks.
Cash: Cash is used for short-term liquidity and spending needs. A cash allocation may provide some additional stability for risk averse investors, while still generating some yield. Cash allocations may vary significantly based on individual goals and circumstances.
More Income and Less Risk: A well-diversified balanced portfolio generally carries significantly less risk than a portfolio focused solely on high dividend-paying stocks. With thoughtful asset allocation and security selection, a balanced portfolio may generate similar income, or potentially even greater income, compared to a dividend-only strategy.
Systematic Rebalancing: A disciplined rebalancing strategy helps manage risk and can enhance returns over time. This involves systematically trimming asset classes that have become overweight and expensive to reinvest in underperforming, but fundamentally sound, asset classes that are relatively cheaper. This “sell high, buy low” approach helps maintain the desired risk profile and takes advantage of opportunities created by market volatility.
Ultimately, focusing on total return (capital appreciation and income), rather than income alone, is crucial for long-term retirement success. A holistic, diversified, systematically rebalanced portfolio provides a more stable, lower-risk, and potentially higher-return path to meeting retirement income needs.
Author: Ryan Wyatt, CFP®, CIMA®
Resources:
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This communication is provided by Wyze Wealth Advisors LLC, a registered investment adviser. All material is for informational and educational purposes only and should not be considered personalized investment advice or a recommendation regarding any specific security, strategy, or product.
The assumptions and scenarios presented are illustrative and do not reflect actual investment results. Projections are based on current market conditions, which may change. Past performance is not indicative of, and does not guarantee, future results. All investments involve risk, including the potential loss of principal.
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