Dividend stocks, more often than not, form the foundation of every great portfolio, especially retirement portfolios. And it makes perfect sense why: Dividend stocks offer three key advantages that attract long-term investors.
Here's why dividend stocks are so critical to your success
To begin with, dividend stocks act as a beacon of profitability. Dividend-paying companies typically have time-tested and profitable business models, and the management at these companies probably wouldn't continue to pay a stipend quarterly or annually if it didn't foresee ongoing profits and growth. In other words, dividend-paying stocks are making investors' weeding-out process of finding their next investment that much easier.
Second, dividend payments can help mitigate the pain felt during inevitable stock market corrections. According to data from Yardeni Research on the S&P 500 (SNPINDEX:^GSPC), there have been 35 stock market corrections totaling 10% or more (when rounded to the nearest whole number) since 1950, or approximately one every two years. While dividend payments aren't going to make up for the short-term paper losses you could incur during a stock market correction, the added income can certainly take the edge off and calm one's nerves.
Last, but not least, you'll have the opportunity to reinvest your dividends via a dividend reinvestment plan, just as the pros do. Reinvesting your dividends into more shares of common stock eventually boosts your payout and increases your share ownership in a repeating cycle. It's one of the smartest ways you can compound your wealth, which is why money managers love it so much.
Dividend aristocrats are kicking the S&P 500s butt over the long term
But, not all dividend stocks are created equally. Among the well over 1,000 dividend-paying companies lies a class of truly elite dividend payers known as dividend aristocrats. These are companies that have increased their payout in each of the past 25 years, if not longer. There are a few dozen stocks that qualify as dividend aristocrats, and they're often considered the cream of the crop for income investors.
As you might expect, some of these dividend aristocrats include brand-name companies such as AT&T, PepsiCo., and Wal-Mart. But there are a host of lesser-known dividend giants, including water utility American Water Works, insurer Chubb, and apparel retailer VF Corporation, which have been putting shareholders first for decades.
The name "dividend aristocrat" might make this group of stocks sound somewhat stodgy, but they're nothing of the sort. Since 1991, dividend aristocrats have collectively kicked the S&P 500's butt in terms of total return. The following illustration, with data from Ploutos, illustrates the difference.
No need to adjust your eyes: If you invested $10,000 in the S&P 500 at the beginning of 1991, you'd have close to $117,000 by the end of 2016. Considering that the S&P 500 underwent a 50% correction during the dot-com bubble and an even steeper 57% correction during the Great Recession, that's a very healthy 25-year return.
However, if you'd invested $10,000 in dividend aristocrats during the same period, you'd have walked away at the end of 2016 with more than $191,000! That's a far superior return to the S&P 500 index, and an even greater reason you should consider adding dividend aristocrats to your portfolio.
Buy one, or buy them all
The thing about Dividend Aristocrats, if you don't know where to begin your search, is that they practically all possess comparative advantages in their respective industries. This doesn't mean you can throw a dart and pick a winner. But over the long term we would expect more of these companies than not to substantially increase in value.
A personal favorite is healthcare conglomerate Johnson & Johnson (NYSE:JNJ), which last week announced that it was increasing its dividend by 5% to $0.84 per quarter. This was the 55th consecutive annual dividend hike for Johnson & Johnson. Beyond its healthy quarterly stipend, J&J has a geographically diverse business model, with over 250 subsidiaries, and around three-quarters of its businesses could be considered inelastic. In other words, because people can't control what ailments they contract, J&J's pharma and medical-device operations are always in demand. That means J&J is probably better suited to handle stock market corrections than even most dividend aristocrats.
Or if you'd rather not buy just one or a couple of dividend aristocrats, you can "collect the whole set," if you will, by buying the ProShares S&P 500 Dividend Aristocrats ETF (NYSEMKT:NOBL). As of March 31, this ETF held 51 S&P 500 dividend aristocrats with at least a 25-year streak of increasing their annual payouts. Buying an ETF does mean paying certain expenses to cover management fees, which according to the prospectus works out to 0.35% annually. However, that could be a small price to pay for exceptional diversity and outperformance over the long run.