Take your eyes off the price
As veteran investment advisors, we frequently get questions from panicked investors about how to stay calm when the market starts to fall. We thought it would be helpful to explain why focusing solely on price is part of the problem.
Charlie Farrell: When it comes to stocks, most people are interested in whether their holdings are worth more than when they purchased them. We've been conditioned to view our investments from a pure price perspective, which leads us to believe that the only way to gain value from stocks is by selling them. But that perspective can lead to many problems - namely undue stress when prices fluctuate.
Fred Taylor: For those focused solely on price, the last two months have been disappointing. At one point in June, the S&P 500 was down more than 7 percent from the 52-week high it reached on May 2, 2011.
But, if the stocks you own also provide you with growing dividends, than the recent sell-off isn't as damaging. Collecting an increasing dividend stream from large, multinational companies versus just hoping that the stock market goes up, is a more prudent way of having your money invested.
Farrell: Dividends can grow at two times the rate of inflation and are not tied to stock prices, leaving investors with a great source of income even when prices decline.
The basic concept of investing in companies that increase their dividends is that rising prices follow rising dividend streams over the long term.
Dividends for the S&P 500 have grown at about 5 to 6 percent per year historically. In today's market, there are opportunities to secure dividends in the 3 percent range that have the potential to grow at 5 to 7 percent in the future. The dividends not only deliver real cash payments into an investor's portfolio, but as those dividends grow, the odds are that the price of the security will follow.
Coca-Cola, for example, saw it's stock price drop from about $60 a share in 2008 to the low $40 range in 2009. The company's dividend payment, however, increased from 38 cents a share to 41 cents a share during that same period. The company's stock is now trading in the $65 to $66 range.
Taylor: Moreover, the management of Coca-Cola prides itself on increasing the company's dividend payments each year and has done so for the past 48 years. Over the last decade, the beverage maker has increased it's dividend payments an average of 10.4 percent.
Farrell: Another company with a powerful dividend history is Johnson and Johnson. From 1993 to 2010, the company's dividend's payments grew from 25 cents a share to $2.11 a share. If an investor had bought and simply held one share of stock of Johnson and Johnson in 1993, that investor would be receiving a return from the dividend payment of almost 17 percent annually today based on what the investor originally paid for that share of stock.
Taylor: If you are getting that type of income return, you'll worry less about what the price of the stock is doing on any given day.
Now, dividends can be reduced, so investors need to be careful about the companies they invest in and create a diversified portfolio of dividends to manage the risks of a potential reduction.
In some cases, companies that pay dividends are providing more income potential for investors than bonds. As was the case in the 1950's, investors can now get more in dividend income from large cap blue chip companies than they can from the 10-year U.S. Treasury bond yielding less than 3 percent.
Farrell: It requires a shift in thinking, but buying based on dividends is an especially wise strategy for retired investors or those nearing retirement. If you're planning to live off the distributions from your holdings, you can't simply hope that the value of those assets will grow. You've got to focus on places where you can generate consistent and increasing income to meet your living expenses.