Stock dividends over time can top bonds, CDs

Your Money

July 16, 2006|By HUMBERTO CRUZ | HUMBERTO CRUZ,TRIBUNE MEDIA SERVICES

Where do you find a well-diversified investment that throws up a dividend yield of almost 24 percent? In the stock market.

OK, that was a trick question (and trick answer). That juicy yield - 23.76 percent to be exact - reflects the dividends you would have received from the stocks in the Standard & Poor's 500 index last year as a percentage of the price you would have paid to buy the stocks in the index in 1970.

That year, your yield would have been 3.36 percent. But as companies in the index kept raising their dividends over time, your "yield on cost" - the annual dividends paid by companies in the index as a percentage of your original investment - would have risen fairly steadily, exceeding 10 percent in 1988 and 15 percent in 1996. Those figures apply to the entire S&P 500 index, not just to companies that pay above-average dividends or raise them frequently.

The composition of the S&P 500 has changed over the years, so these computations are not totally accurate. But my point remains valid: If you have time on your side, a long-term strategy of investing in companies with a consistent history of raising dividends can provide a growing stream of income.

And that growing income, while lower at first, eventually can surpass the fixed payout you can receive from bonds and certificates of deposit, and help you stay ahead of inflation.

In addition, under recent legislation, qualifying stock dividends will be taxed at lower rates than income from bonds and CDs through 2010.

I use this dividend-growth strategy for part of my money with the twin goals of generating some income now and a higher income than I could expect from bonds in 12 to 15 years. I think this strategy is overlooked by many income investors with a myopic focus on finding just the highest current bond yield.

This strategy, as do all that involve investing in stocks, contains risks. Stock prices can go down, a company can stop raising, cut or even eliminate its dividend, and tax laws can change. I'm not recommending any specific stocks or mutual funds. To avoid even the appearance of a conflict of interest, I am quoting only managers of funds I consider worth exploring but that I do not own.

"The wonderful thing about the strategy is that it is appropriate for everybody," said Brad Kinkelaar, co-portfolio manager of the Thornburg Investment Income Builder Fund. If you don't need the income right away, you can reinvest the stock dividends in additional shares, "and when the time comes, you have access to a growing income stream," Kinkelaar said.

Historically, reinvested dividends have accounted for more than 40 percent of the stock market's return, a fact that may surprise many investors.

"It frustrates me a little bit that I don't think people still understand the impact that dividends can have on your total return," said Tom Huber, manager of the T. Rowe Price Dividend Growth Fund. Particularly during periods of stock price declines, "It is reassuring on a quarterly basis to get a check in the mail" for a company's stock dividend - or at least a notice that a dividend has been paid, if you are reinvesting it.

There are many ways to invest in dividend-paying stocks, from building your own portfolio through a broker or from companies selling shares directly to the public, to picking mutual funds or exchange-traded funds that follow a dividend strategy. But dividend funds can differ substantially in their approach.

More than most others, for example, the Thornburg fund includes foreign dividend-paying stocks as part of a globally diversified portfolio, and also invests in bonds.

Both the T. Rowe Price and Thornburg funds look for solid companies with a history of raising dividends and the capacity to continue to do so. Other funds and exchange-traded funds set a minimum yield for the stocks in their portfolio or select only from those that meet certain criteria on current yield and/or previous dividend increases.

If the topic interests you, I suggest you consult a trusted financial adviser and/or do your own research. Sources I've found useful include past issues of the AAII Journal, the magazine of the not-for-profit American Association of Individual Investors (www.aaii.com or 800-428- 2244) and of the Outlook, an investment advisory newsletter from Standard & Poor's (www.outlook.standardandpoors.com), which I've found at many public libraries.

For research on mutual funds and exchange-traded funds, check the Web site of Morningstar Inc. (www.morningstar.com).

Humberto Cruz writes for Tribune Media Services.

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