The ideal situation for anyone living off their investments is for your portfolio to generate enough income so that you never have to touch your principal. With interest rates having fallen to rock-bottom levels in recent years, however, finding sound, secure investments that pay you enough income to get by has become an increasingly difficult challenge to overcome.
Fortunately, there's a strategy that will let you get the money you need from your portfolio without choosing stocks that are riskier than you're comfortable owning. It's not the perfect solution for everyone, but it provides a different view of your portfolio that focuses less on pure income and more on choosing the best overall investments you can find.
Why dividend stocks have become so popular
The reason that so many investors have gravitated to dividend stocks is simple: Most of the good alternatives have disappeared. Rates on 10-year Treasury bonds remain stubbornly under 2%, and most corporate bonds pay only small premiums to Treasury rates. Bank CDs generally yield between 1% and 2%, even if you're willing to lock up your money for several years. In order to get solid yields, you have to be willing to take on the increased default risk of speculative-grade high-yield bonds -- a sacrifice in quality that many investors are reluctant to make.
In an effort to make up for shortfalls from bonds and other traditional income investments, many retirement investors have increased their portfolio risk level by loading up on dividend stocks. But in many cases, finding stocks with dividend yields that are high enough to meet your income needs involves buying into companies whose futures are uncertain.
For instance, take the mortgage REIT industry. The double-digit yields that many mortgage REITs offer are unquestionably among the highest the market has to offer. Yet in the current environment, they come with a lot of uncertainty. Industry leader Annaly Capital (NYSE:NLY) has seen its dividend decline in recent years, and with its proposed buyout of Crexus (NYSE: CXS), many believe that Annaly's core business model may be under threat from the Federal Reserve's actions to buy up mortgage-backed securities. Meanwhile, Chimera Investment (NYSE:CIM) is a less-leveraged alternative, but it hasn't provided full financial statements for years, raising concerns of what investors will find when Chimera gets around to providing them.
How to avoid chasing yield
Many investors need the double-digit returns that mortgage REITs provide because they haven't put enough money aside for their retirement. But if you need to grow your portfolio, investing in growth stocks makes more sense than sticking with dividend payers.
Occasionally, those two categories overlap. For instance, 3M (NYSE:MMM) has risen to all-time highs recently, as an improving economy bolsters the prospects for the diversified conglomerate. Yet the company also has a decades-long track record of increasing its dividend annually.
But if you rely only on dividend stocks, you'll miss out on big winners. Google (NASDAQ:GOOGL), for instance, doesn't pay a dividend, but its long history of growth and innovation has led to huge share-price gains.
Pay attention to return
In the end, what's important is for your portfolio to rise in value to provide you with some money to spend. Whether that increased value comes from cash dividends or from stock-price capital gains is irrelevant, except to the extent that you choose to consider selling shares for spending money as invading principal. If you pay attention to finding the stocks with the best total return potential, then you'll be able to pick safer stocks than you would if you add the arbitrary extra requirement that they pay a hefty dividend. Don't take on more risk than you need to.