Wednesday, November 16, 2011

How to create a bulletproof dividend portfolio

Investors who plan on living off their assets in retirement face several risks. The risks include inflation, longevity risks, extreme market conditions and liquidity. By creating a diversified dividend portfolio however, investors could not only address these risks, but have a very good odds of achieving a rising stream of dividend income, which means that they would never have to dip into principal to finance their retirement.

The first risk includes inflation. Over the past century, inflation has averaged 3% per year. While the effects of inflation are not visible over a period of five years or less, over the long run its eroding effect is significant. Even at 3%, the purchasing power of the dollar decreases by 50% in 24 years. That means that a bottle of Coca-Cola which costs $1.25 would likely cost $2.50 in 2034. Investors should realize that this is just an average however. Some costs would increase much faster than the average, while others would likely decrease over time. As a result, investors should be able to invest in assets which not only generate an inflation adjusted stream of income but also protect the purchasing power of their principal. I have discussed such investments in this article.

Companies such as Procter& Gamble (PG) and Coca Cola (KO) have the pricing power to pass cost increases over to their consumers. As a result, their earnings should be able to increase if there is any inflationary pressure.

The second risk is longevity risk. Investors typically depend on the four percent rule, which requires that a set percentage of one’s portfolio is sold each year, no matter what. In an event of an extended flat market, or if the retiree happens to have started retirement during a significant stock market top like the one in 1929 or 2000, then they would likely deplete their assets in less than 2 decades. A male that was born in 1946, is expected to live 19 more years according to this SSI Life Expectancy Calculator. The problem is that this is just an estimate – a major portion of those which have chosen to retire at 65 would likely live longer than average. Running out of money in retirement should never be an option, since it is impossible to predict the life expectancy of an individual with any precision.

Dividend Growth Investors do not have to worry about longevity risks, as long as they hold a properly diversified dividend portfolio. This portfolio should include at least 30 individual securities representative of as many sectors in the economy as well as a variety of geographic areas. This portfolio should also include certain noncorrelated assets such as fixed income as well. For an example dividend growth portfolio for the long term, check this portfolio. The process of building a bullet proof portfolio should take some time, as not all great dividend stocks are attractively valued at all times.

The third risk includes extreme market conditions. This could include bear markets, recessions and depressions. The beauty of most quality dividend stocks is that while their prices fluctuate with the market, their dividend payments are stable and even rising. As a result, investors are essentially paid for holding on to their investments. As long as the carefully selected dividend stocks maintain their profitability and can afford to pay the distributions, investors should do exactly that – hold on to their positions. Selling your stocks just because the market is down 20%- 30% and all the doom and gloomers are predicting the end of the world is not a good idea if the dividend is maintained or increased, unless of course the dividend is cut or eliminated. In order to withstand market corrections caused by recessions, investors should have a properly diversified dividend portfolio which has proper representation from the ten sectors in the S&P 500. Adding some international stocks could also reduce volatility in dividend and stock price returns as well. During the financial crisis of 2007 -2009 most of the dividend cuts were concentrated in the financial sector as some dividend aristocrats like Bank of America (BAC) and US Bancorp (USB) cut distributions. At the same time however, companies like PepsiCo (PEP) and McDonald’s (MCD) kept raising dividend stocks. This means that if dividend investors were properly diversified using the above mentioned principles, the effect on the financial crisis on their dividend income would have been insignificant at worst.

The fourth risk is liquidity. Investors who purchase annuities typically are able to generate a stable stream of income in exchange for handing over their nest egg to an insurance company. They pay a fee for this service, and have their money locked up. The annuity payment typically does not grow over time, which decreases the purchasing power of the income stream. If the retiree tries to sell the annuity, they would be hit with a large number of steep fees. In addition, most annuities stop paying income once the original participant is deceased. They could be extended to provide a payment to the participant’s spouse, but this would result in a lower current payment. This means that the next generation would not be able to benefit from the wealth accumulated by the retiree.

Investors who depend on dividend stocks for income in retirements, do not face any liquidity risks. Most of the best dividend stocks are actively traded blue chips, which could be sold every day that the market is open. Investors living off dividends should not dip into principal unless there are extreme circumstances, which absolutely requires this to happen. For example, Johnson & Johnson (JNJ) trades an average of 12 million shares per day. This means that unless the size for your trade is in the tens of thousands of shares, liquidity should not be an issue. That being said, most dividend investors focus on the long term dividend potential of their income stocks. However, knowing that your portfolio is quietly appreciating as well because of the higher earnings generation capacity of the business, is always appreciated as well.

Full disclosure: Long JNJ,PG, MCD, PEP, KO

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