Should You Go With Stocks or Bonds for Income?

The conventional wisdom is clear: Bonds are best for people in or near retirement. They provide the desired income and can be much more reliable than stocks. Well... yes and no, if you ask me.

Bonds do have some advantages. Those issued by the U.S. government offer income that's rather dependable. Even corporate bonds can be fairly reliable. That's a big deal, but beyond that, I'm having trouble coming up with other advantages. Oh, here's one more -- bonds can offer some diversification to your portfolio, as they don't always move in step with the stock market.

Stocks, though, have many advantages:

• Over long periods, stocks have outperformed bonds. Period. They have done so more than 95% of the time in the 20-year periods between 1871 and 2006.
• Dividend-paying stocks can offer yields that top those of most bonds. Last time I checked, government bonds with two- to 10-year maturities had yields of around 1% to 3.5%, while 30-year bonds offered about 4.25%. Well, it's not hard to find solid dividend stocks paying yields of 3% or more. Take a look at these stocks:

Source: Motley Fool CAPS.

• Interest payments from bonds will lose value over time, due to inflation. With inflation at its average of 3%, the value of an interest payment will fall by almost half over 20 years. If inflation tops its historical pace, as it might in coming years, then interest payments will hold even less purchasing power. That's because bonds don't increase their payouts in line with inflation -- except for TIPS, of course.
• Stock dividends, though, tend to be increased over time, and often at an inflation-beating rate. Indeed, over 20 or more years, you can see a 3% yield become an effective yield of 20% or more in relation to your purchase price.
• Dividends aside, healthy and growing dividend-paying companies will see their stock prices rise over time, too, giving shareholders a powerful double benefit. Even behemoths like Wal-Mart (NYSE:WMT) can grow -- its annual revenue grew 7% between fiscal 2008 and 2009. Its dividends have grown by an annual average of 20% over the past 20 years.
• For the time being, tax rates favor dividends, with most of us facing a 15% hit on dividend income. Bond interest, though, gets taxed at our ordinary income rate, which can be 25% or higher.
• And finally, right now is a particularly good time to buy into dividend payers, as so many are on sale, with low stock prices driving up yields.

So do give dividend-paying companies serious consideration for your portfolio. Perhaps combine them with bonds as you near and enter retirement. Remember that many dividends are darn reliable -- plenty of companies have been paying them for more than 100 years.

Learn more in these articles:

• Robert Brokamp explains how bonds can help save you from a market that's already worse than the Depression.
• Here's how you can salvage your retirement.
• Read our introduction to asset allocation.