There is a common misconception among retirees that a heavy concentration in dividend-paying stock is necessary to create retirement income. Their plan is to invest most of their portfolio in dividend stocks and cover living expenses with dividends as they are issued.
A better option is to create a diversified portfolio containing a mix of fixed-income investments, dividend- paying stock mutual funds and growth-oriented stock mutual funds.
Rather than depending on dividends for a direct income source, create a bucket strategy to meet short-term income needs and manage risk. Keep money that is needed in the next 12 months in highly liquid accounts such as a checking, savings or money market accounts. Place money to cover at least five years of expenses in bonds, bond funds and CDs.
If you have a lower tolerance for risk, keep a larger percentage in fixed income. Invest long-term money in the stock market in a combination of mutual funds that invest in growth companies and mutual funds that invest in dividend-paying companies — be sure to reinvest the dividends.
Rebalance your portfolio annually to stay on track to your plan and replenish your liquid accounts.
Dividends are payments of profit made to shareholders. They are generally paid by well-established companies that have passed the growth stage. Rather than reinvest earnings into the growth of the company, they distribute earnings as a dividend. The payment of dividends decreases shareholder equity, and the stock price is decreased by the value of the dividends paid. Dividend-paying companies tend to be more stable, but dividends may be decreased during difficult times. They also experience less appreciation in stock value than growth companies.
Growth companies are generally smaller, expanding companies that reinvest earnings back into the company. They are more sensitive to economic events that can impact future projects. They are expected to grow faster and offer higher upside potential than dividend paying companies, but they are more risky.
The purpose of the money in the stock portion of your portfolio is to provide long-term growth. The focus is to maximize total return from a combination of stock appreciation and the reinvestment of dividends. In some years growth stock will outperform dividend-paying stock and in other years it may be the opposite. This combination provides diversification, which helps balance fluctuations in the stock market. Additionally, the reinvestment of dividends enables you to dollar-cost average where you buy more shares when the stock is low and fewer shares when it is high.
Finally, using a bucket strategy for retirement income rather than maintaining a portfolio of predominantly dividend-paying stocks can provide more control over your taxes. Dividend-paying stock, in a taxable account, accelerates your taxes. You owe taxes in the year the dividend is paid, where tax on the appreciation of stock is deferred until it is sold.