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Submitted by: Bill Cleveland
The author is a fee-only certified financial planner (CFP®) with Preston & Cleveland Wealth Management, LLC in Augusta and Atlanta, GA. He is a member of the National Association of Personal Financial Advisors (NAPFA) and provides comprehensive financial planning and investment management services to high net worth individuals and retirement plans across the country. Bill was recently selected as one of The 150 Best Financial Advisers for Doctors in the country by Medical Economics magazine.
Article as of May 2008
As the Baby Boomer generation prepares for retirement, there is an increasing need for income generating investments. To meet this demand for income, there have been a number of funds and products introduced over the last several years, and many more to come. As the 10 year U.S. Treasury bond fluctuates between 3.5% and 4.0%, it is understandable that investors are searching for ways to increase the income or yield from their portfolio. The term “yield” can mean a number of different things depending on the context it is used in, so it is important to perform thorough due diligence prior to making an investment decision.
Investors should focus more on the investments “total return” than on the yield of the investment. Total return incorporates capital gains and losses on the principal of the investment, as well as the “yield” or income component.
In the investing world, the saying “if it sounds too good to be true, it probably is” is always important to remember. Anytime you are offered a return above the risk free rate of U.S. Treasuries you should ask yourself several questions:
- What are the goals for this part of my portfolio? Is it income, stability, and security or is it for growth?
- What are the risks I am taking for this perceived extra yield? Is a higher yield really better in the context of the principal risk I am taking?
- How is this investment able to offer this extra yield?
- What are the costs for receiving this extra yield (i.e. surrender charges, lock-up periods, and high fees)?
- What is the advisor’s total compensation for this option versus other options recommended to me?
In our first column on yield, we will focus on dividend paying stocks. In the high growth 1990’s, investors viewed dividend paying companies as antiquated. Why would you invest in a company with a 3% dividend when you can earn 20% a year? As investors begin to have more realistic expectations for returns and healthier investment behaviors, individuals are realizing that dividend paying stocks deserve a place in a portfolio. Whether you are accumulating assets or moving toward retirement, dividend paying stocks can provide a source of income to help a portfolio keep pace with inflation as well as some capital appreciation over time.
While dividend paying stocks or funds can be great additions to a portfolio, it is important to understand the risks. The term dividend yield is calculated by dividing the “expected” annual dividend for the next four quarters by the closing price of the stock. By looking at the formula, you can understand the risks. The numerator is based on “expected” annual dividends, this can always change. The denominator is based on the stock price, so as the stock price decreases, the dividend yield increases.
A high dividend yield could mean that the company is in trouble and that there is a potential for a dividend cut in the future. A recent example of this is Citigroup. On January 14th, shortly before its dividend cut, Citigroup had a dividend yield of 7.7%. The yield had increased over the last year as Citigroup’s price had decreased close to 50%. In an effort to conserve cash and rebuild its balance sheet, Citigroup cut its quarterly dividend from 54 cents to 32 cents, or about 41% the first part of this year.
One of the more popular exchange traded funds (ETFs) is the Ishares Dow Jones Select Dividend Index fund (DVY). As of March 31, 2008, this ETF had a yield of around 4.6% and a low expense ratio of .4%. Keep in mind that many dividend paying funds do have a high exposure to financials and utilities, with DVY at 48% financials and 17% utilities as of March 31, 2008. Given its high exposure to financials, DVY through March 31, 2008, was down 15.73% over the last year. The lesson here is that just because funds pay a high dividend does not mean that they are immune from downturns; you are still investing in stocks. The second lesson is for any investment you purchase, make sure you “look under the hood” and are comfortable with the underlying investment options and sector allocations. In addition to ETFs, no-load fund companies like Fidelity, Vanguard, and Thornburg all have highly rated dividend paying funds for you to consider.
One added layer of uncertainty going forward is the taxation of capital gains and dividends. Under current law, dividends and long-term capital gains are taxed at a federal rate of 15%. However, this rate is set to expire at the end of 2010, with dividends then being taxed at ordinary income tax rates.
As the last year has demonstrated, dividend paying stocks are not a sure thing and can be as volatile as the stock market. These funds should always be used in the context of an overall investment strategy. If your goal is income and stability, then these funds are not appropriate for your portfolio. If your goal is income and growth over a long-term time horizon, then you will find that dividend paying stocks will be a nice addition to a portfolio.
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