Market risk is weighing on the minds of many investors these days. And who could blame them, given the market's twists and turns over the past few years? While stocks are always going to be riskier than bonds, it's possible to invest more conservatively in the stock market by buying dividend-paying stocks, which can provide a cushion for investors during tough times. Here are six reasons to consider adding dividend-paying stocks to your portfolio.
Guaranteed returns. These stocks pay a cash return (usually quarterly) regardless of whether their share price is up or down. "Dividends can rise and fall with economic conditions," says Josh Peters, editor of Morningstar's DividendInvestor newsletter. "But in general, if the market drops 200 points tomorrow, chances are that a portfolio of dividend-paying stocks is going to have the same income if the market were to go up 200 points." (Dividend payments aren't guaranteed, but many companies have a history of raising or at least holding their dividend steady over time.) Peters says that generally, a company will set its dividend at a level that can be consistently maintained for an indefinite period of time. And when a company raises its dividend, it's an indication that the firm believes it can fulfill that pledge over a long period of time, he says.
Long-term potential. Instead of trying to time the market by moving in and out of stocks, Peters says, investors should focus on buying solid dividend-payers and holding onto them over a long period of time. "You make one trade and hopefully that's a stock that you don't ever have to sell—or if you do sell it, it's going to be years down the road. And in the meantime you've been collecting a fair amount of dividend income," he says. Not all dividend-paying stock are sure bets, but Peters argues that investors are much better off investing in dividend payers than stocks that offer little yield.
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Dividend payers tend to be solid companies. If a company is able to pay a dividend on a consistent basis, it has a good amount of cash on hand. Strong cash flows are often a sign of a mature company that's stable and competitive in its industry. Such companies also tend to carry less debt. "You just really wind up with a better class of company when you're looking at a dividend-paying stock, especially if it's a higher yielding stock," Peters says.
Some stocks are yielding more than bonds. It's rare, but it happens. In a sign of the times, some companies have recently begun to issue new 10-year bonds with lower yields than their current stock dividend. Peters points to a recent offering by Johnson & Johnson. In early August, Johnson & Johnson sold $550 million of 10-year notes at a yield of 2.95 percent. On the same day, the company's stock closed with a dividend yield of 3.69 percent, according to Peters. He believes a large-cap, dividend-paying stock has the potential for a much better return over the next 10 years than a bond issued by the same company. Peters says J&J has consistently raised its dividend for decades, and buying a bond with a lower yield that's issued by the same company would be foolish. "Even if the dividend was just flat over the next couple 10 years, you'd still make more income from owning the stock than you would from that bond," Peters says. With many bond yields as low as they are currently, some investors may want to consider dividend-paying stocks that have better long-term prospects for gains. Risk tolerance, of course, is a factor.
The market's long-term returns come mostly from dividends. Daniel Peris, manager of Federated Strategic Value Dividend (symbol SVAAX) says dividends account for about 90 percent of the S&P 500 Index's long-term returns. Believe it or not, only about 10 percent of the S&P's total return comes from upward movement in the share price of stocks that make up the index. "There have always been speculators, but by and large, most investors view the stock market as an income-receiving mechanism," Peris says. In the late 1980s and 90s, Peris says investors were infatuated with the stellar returns of the major stock indices. But now, he says, it's time to get back to basics. "If you eeked out a zero last decade it was because your stocks were down a couple of percentage points and your dividends made up the difference," he says, referring to the S&P 500's "lost decade."