The Alternative to Low-Interest Saving: How to Invest in Dividend Stocks

Bob is a 70-year-old retired hospital administrator who has spent the last decade volunteering in West Africa with his wife, a nurse, to help improve the hospital systems there. (He asked his full name not be used.) Now back home in California, the Vietnam veteran and father of two is worried about the nest egg he built over four decades.

"I have too much money in a money market account, and it's hard to watch its purchasing power decline as inflation eats up the paltry earnings," Bob says.

Bob's dilemma is one that's shared by millions of retirees. With interest rates at historic lows, there are far fewer options for drawing a steady income stream from your nest egg. Just over a decade ago, someone who had $1 million saved for retirement could park it in simple CDs and get more than 5% interest, providing an annual income above $50,000. Today, the same investment strategy would yield about 0.3% -- or an income of $3,000.

That's why Bob and many other retirees are looking more closely at stocks that pay dividends -- a portion of the company's earnings -- to shareholders, typically each quarter. Dividends are usually quoted in the dollar amount per share. An investor who owns 10,000 shares of a company with a dividend of 8 cents a share will receive $800 over the course of the year. But simply choosing a handful of the highest-yielding shares is not the best approach, experts say.

'High Yield Isn't Necessarily Safe Yield'

"Prior to the financial crisis, the dividend yields on a lot of bank stocks and other financial stocks were quite attractive before they cratered," says Cal Brown, a Virginia financial planner. "You can't just go by the dividend yield thinking it will protect you on the downside." Dividend yield refers to the dividend as a percentage of the current stock price. Back in December 2007, the dividend yield of IndyMac Bancorp was 11.8%. It filed for bankruptcy eight months later.

"High yield isn't necessarily safe yield," agrees Farrell. "You really have to think about owning a collection of operating companies diversified across industry sectors to protect yourself against a couple that may flame out." Farrell's firm, Northstar Investment Advisors, has developed its own dividend-focused index, with returns certified by S&P, that it uses to model client portfolios.

The ideal is to own a broad mix of blue-chip companies that produce meaningful income -- but also grow that income. For example, Standard & Poor's assembles an annual list it calls the "Dividend Aristocrats" -- companies that have paid and increased their dividends for at least 25 years. "It's the growing dividend that's really important for people, because otherwise you won't have a portfolio that outpaces inflation," says Farrell.

To get the advantages of dividend-paying stocks without buying individual shares, consider an equity-income mutual fund, in which a professional manager chooses the stocks in the fund. Managers look for dividend-paying stocks that also have the potential to appreciate in price (offering solid total return). Examples include the Vanguard Dividend Growth Fund (VDIGX) and the T. Rowe Price Equity Income Fund (PRFDX).

Corporations Have Big Cash Stockpiles

Investors should also consider value funds, says Brown, even if they are not dividend-specific. "If it's truly in the value category, almost assuredly it will have reasonably good dividend yields because those are the kinds of stocks they are going to be buying," says Brown. He advises investors to diversify their portfolios with a mix of large-cap, small-cap and international value funds, which may also contain bonds.

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Also consider an exchange-traded fund that focuses on dividend-paying stocks. ETFs track the performance of specific market indexes – such as the S&P 500 – but trade like stocks. (Mutual funds, by contrast, are priced just once a day, when markets close at 4 p.m. Eastern.) ETFs often claim to be have lower costs and better tax-efficiency than mutual funds (although some studies have found low-cost mutual funds can beat ETF returns). Examples include the iShares Dow Jones Select Dividend Index (DVY), the SPDR S&P Dividend (SDY) and the recently launched Schwab U.S. Dividend Equity (SCHD).

Whether you choose a mutual fund or ETF, make sure the basket of investments isn't dominated by a handful of big names, says Farrell. Most of the broad market indexes, such as the S&P 500, are "market cap-weighted" -- meaning the index holds a larger percentage of the biggest stocks. Wild price swings in those shares can have a dramatic effect on the overall value of the index, fund or ETF.

The outlook for dividend growth is positive, given that companies are sitting the biggest stockpile of cash in nearly 50 years.
"There's plenty of money that can be delivered to shareholders through increased dividend payouts," says Farrell.

If you do choose the route of simply buying a diversified basket of dividend-paying stocks, be prepared to ride out the market's ups and downs, advises Brown. "You can buy individual stocks right now with a 4% to 6% yield, but you've got to be prepared for the downturn and say, 'I believe this stock is not going out of business and will eventually recover,'" he says. "Take the dividend check and be happy and don't pay attention to the volatility. A lot of people say they can do it until the price drops by 20% to 25%, and then they're not so sure."