Why Dividends are Critical

Conservative investors by definition invest where the risk of capital loss is extremely low. As such a lot of their money is in savings accounts, money market accounts and CDs. While there is nothing wrong with this approach in ensuring safety of principal, the problem arises when investors are seeking an income from their capital.

According to the BestCashCow Savings Rate page, the highest yielding savings rate is from Everbank at 2.25%. The next best is 1.75% while there are a number of banks offering 1.5%. For CD rates, the best one year rate is 1.80% and the best 18 month CD 1.90%.

Investors who are looking for income thus invest in these accounts and produce a marginal income stream, which may or may not be sufficient for living costs. The problem with these rates, however, is inflation.

Inflation is defined as a rise in the general level of prices of goods and services in an economy over a period of time. Inflation is the enemy of the income seeking investor because it erodes the value of money over time. For example, assuming the inflation rate is 2%, a person who invests $1 today will need $1.02 just to stay at the same level of purchasing power. If that person’s investment compounds at a rate below inflation, they are losing money.

So given the above rates available to the conservative investor in savings accounts and CDs, is he keeping up with inflation?

The answer, I’m afraid, is a resounding no. The United States inflation rate currently sits at 2.31% (according to the Bureau of Labor Statistics).

Assuming an investor has $1 million to invest, and decides to place their money with the best available CD at 1.80%. At the end of a one year period, the investor will have $1,018,000. A simple calculation using the inflation number shows that the investor needed to reach $1,023,100 just to stay even. The investment into the savings account has therefore generated a real loss for the investor of $5,100.

Where is an investor able to generate an income above inflation without incurring significant risk over the long-term? The answer: dividends.

The S&P 500 Index yields, by co-incidence, 2.31% in dividends annually. An investor who simply buys the index at the current price can therefore match inflation based on the dividend yield. Buying the index is easy: most major brokerage firms have a tracking product at low cost that mimics the dividends and returns of the index.

Of course buying a passive index is not a great way to protect capital, which of course is the primary concern of any investor. As such, looking into the highest yielding Dow stocks is a good way to find dividend yield above that of inflation which are both sustainable and reliable. Some examples include Coca-Cola (KO) yielding 3.29%, Johnson & Johnson (JNJ) yielding 3.34% and Procter & Gamble (PG) yielding 3.28%.

Of course there’s always a risk investing in equities. The risk, however, is far greater in eroding the real value of your money due to inflation, which leaves an investor worse off the longer his money earns a rate of return below that of inflation.

To see the BestCashCow Dividends page, click here.