Why Dividends Beat Bonds in My Book

How are you planning to fund your retirement?

"Save a big pile of money beforehand" is the answer I usually hear, especially from younger folks. And it's not a bad goal. But even if you're diligent about saving every month, it's something of a long shot, thanks to Mr. Market's occasional tendency to moodiness.

Fortunately, it's not too hard to save a decent amount before you leave work for the last time, and to do it with investments that will give you an income stream in later life. And my money is (literally) on the great benefits of dividend stocks, despite the concerns of some folks, like my colleague Dan Caplinger, who argues that dividend stocks are no replacement for bonds.

Why dividends should fund your retirement
It's no secret that dividend stocks have become popular with retirement investors in recent years. And with good reason: The best dividend stocks, those of blue-chip companies with a long history of raising their dividends every year, have advantages for retirement investors that few investments can match.

The biggest advantage is that the dividends can be reinvested for extra growth -- a particularly powerful technique to use in a tax-advantaged account like an IRA -- or taken as income once you're in retirement.

That added growth can be a big deal. One of the other key benefits of dividend stocks -- that they're less volatile than growth stocks, and thus less likely to take big losses when the market takes a swan dive -- comes with an implicit downside: Their prices probably won't go up as much during roaring bull periods. But reinvested dividends can help make up the difference.

For instance, take a look at Southern Company (NYS: SO) , a very well-managed electric power provider. Southern's stock has done better than many utilities', but it's no moon rocket. If you'd bought it 10 years ago, you'd be up about 66% now. That's not too shabby, but it pales in comparison to the 167% return you'd have if you had reinvested the dividends.

That return puts it in a different league, a league with other great dividend stocks, like pharma giant Johnson & Johnson (NYS: JNJ) , which could be about to raise its dividend for the 50th consecutive year. Or 3M (NYS: MMM) , the famous Scotch Tape and Post-It king, which is really a well-diversified industrial giant that has raised dividends for 53 years running. Or Philip Morris International (NYS: PM) , a big-dividend (3.5% yield) tobacco giant that operates only outside of the U.S. and thus isn't exposed to the regulatory risks facing Big Tobacco here.

But about those bonds
In the new issue of the Fool's Rule Your Retirement newsletter, advisor Robert Brokamp argues, like Dan, that bonds have gotten a bad rap. Bonds, he argues, aren't nearly as vulnerable to Mr. Market's mood swings, can help lower the risk level of your overall portfolio, and the income they provide can help your portfolio grow -- and provide for your expenses after you retire. And unlike dividends, a bond's yield won't be cut if the company hits a rough patch.

Sound familiar? It's true that well-chosen corporate bonds can offer some of the same benefits you'd get with dividend stocks. But there are some downsides, starting with a biggie: Bond prices fall as interest rates rise. With interest rates still near historic lows, that's likely to be a problem in the future, unless you plan on holding all those bonds to maturity.

More to the point, though, is that bonds are unlikely to give you the growth of stocks over time. I was just looking at a bond issued by Ford (NYS: F) , the resurgent American automaker, that would yield just under 6% if you bought it today and held it to maturity in 2022. That's better than the yield on most dividend stocks, but unlike stocks, that almost-6% is all you're going to get if you hold the bond to maturity.

Still, it's true that bonds can have a useful role in your retirement portfolio, and the debate over bonds versus dividend stocks is one I'd encourage you to explore. Check out the new issue of Rule Your Retirement for the full scoop.

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At the time thisarticle was published Fool contributor John Rosevear owns shares of Ford. Follow him on Twitter at@jrosevear. The Motley Fool owns shares of Johnson & Johnson and Ford.Motley Fool newsletter serviceshave recommended buying shares of Philip Morris International, Johnson & Johnson, 3M, Southern, and Ford, as well as creating a synthetic long position in Ford and diagonal call positions in 3M and Johnson & Johnson. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days.The Motley Fool has adisclosure policy.

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