Are Dividend Stocks Really Safer? What Every Retiree Should Know

Dividend stocks have a comforting reputation: steady income, familiar blue-chip names, and a payment that shows up whether the market is up or down. If you're near retirement or already there, that sounds like exactly the kind of safety you want. But here's the question worth asking before you move a big chunk of your savings into them. Are dividend stocks actually safer, or do they just feel that way?

After a lot of research, my honest answer is that they can be less risky, but it's not a given.

Dividend stocks can feel safe and steady, but they still carry real stock risk, and an unusually high yield often hides more than it reveals.

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First, What Is a Dividend?

A dividend is simply a portion of a company's profits that it chooses to pay out to its shareholders. Many retirees are drawn to dividend stocks because they can either reinvest those payments or use them as income, all while holding shares in well-established companies.

The appeal is real. Buenough.

The Cons Retirees Often Overlook

1. t the pros are already well known, so let's focus on the cons that don't get talked about nearly They're still individual stocks. That means individual stock risk. You could lose some, all, or a substantial part of your investment in any single name.

2. Paying the dividend reduces the company. When a company pays out cash, its value drops by roughly the amount paid.

3. Dividends can limit growth. Money paid to shareholders is money the company can't reinvest back into the business.

4. In a taxable account, dividends are forced taxation. Even if you reinvest them, you're taxed on those dividends in the year you receive them.

5. Leaning on a dozen stocks for income is risky. If you're a retiree depending on those payments, concentrating your income in a small handful of companies adds fragility.

6. Dividend stocks are not a substitute for bonds. They behave like stocks, because they are stocks.

None of this means dividend stocks are bad. For the right long-term investor, a portfolio of lower-volatility, dividend-paying shares of solid companies can make sense. You just have to go in aware of individual stock risk and sector risk, and accept that from time to time some of your holdings will take a sharp drawdown, sometimes falling further than the broader market.

How to Size Up a Dividend Stock

Two quick measures help you evaluate a dividend stock:

• Dividend yield. This is the annual dividend per share divided by the share price. Yields can range from under 1% to nearly 10%. Be cautious with excessively high yields, which can be a warning sign rather than a gift.

• Payout ratio. This is the percentage of earnings a company pays out as dividends. A healthy range is generally 30% to 50%. Anything above 50% may not be sustainable.

For a deeper look, you can also examine the dividend coverage ratio, free cash flow to equity, and net debt to EBITDA (earnings before interest, taxes, depreciation, and amortization).

Even Blue Chips Can Stumble

Offering a dividend today doesn't protect a company from a falling share price or a dividend cut, and sometimes both happen at once. Over the years, plenty of household-name dividend payers have gone through long stretches of poor performance, and some have trimmed or suspended their dividends entirely, even after decades of steady payments. The point isn't to single out any one company. It's that most stocks will have dramatic drawdowns at some point, and when you own only 20 or so of them, a couple of bad ones can drag down your entire portfolio.

Why ETFs Often Make More Sense

Picking individual stocks successfully is very hard, even for professionals. That's why I generally point people toward ETFs. A single ETF often holds 50, 100, or more companies, which makes it far easier to reduce or eliminate individual stock risk. Diversification really is the closest thing to a free lunch in investing.

With hundreds of low-cost ETFs available, you can build a portfolio that fits your goals while staying diversified. If your aim is to lower equity volatility and remove single-stock risk, a mix of low-volatility and dividend equity ETFs may make sense, and many come with very low expense ratios. Sector ETFs can play a role too. The three sectors that have historically been more defensive are consumer staples, utilities, and healthcare. Just be careful not to get too overweight in any one sector, because concentration adds its own risk.

Are Dividend Stocks Really "Defensive"?

It depends. A Morningstar strategist examined six recessionary periods going back to 1980. In three of them, dividend stocks beat the broad market. In the other three, the broad market won. So while dividend stocks are often thought of as defensive, that reputation doesn't hold up in every downturn.

A Newer Option to Know About: Option Income ETFs

Lately a newer category has been getting a lot of attention from retirees hungry for income: option income ETFs, sometimes called covered-call or premium-income funds. These funds generate income by selling options, usually covered calls, on their holdings and then passing the premium along to shareholders, often as a monthly distribution. The headline yields can look far higher than anything a traditional dividend stock offers.

The appeal for retirees:

• A high, frequently monthly, stream of income

• Built-in diversification when the fund is based on a broad index

• A cushion in flat or mildly down markets, since the option premium offsets some of the decline

• A hands-off approach, since the fund runs the options strategy for you

The catch:

• Capped upside. Selling covered calls means giving up much of the gain in a strong rising market, so long-term total return can lag a plain index fund.

• The yield can be misleading. Part of that eye-catching distribution can be a return of your own capital rather than true income, which can quietly erode the fund's share price over time.

• Income can be unpredictable. Distributions often vary from month to month.

• Taxes can get complicated, with distributions mixing ordinary income, capital gains, and return of capital.

• Higher costs. Expense ratios tend to run above simple index ETFs.

• They still fall in sharp downturns. The premium only softens the blow so much.

And they are not all created equal. This is the part that matters most. A covered-call ETF built on a broad index like the S&P 500 or Nasdaq 100 is a very different animal from a single-stock option income fund, which is far more concentrated and far riskier. Strategies vary too: some write options against the entire portfolio for maximum income and minimum upside, while others write against only a portion to keep more growth potential. And the highest-yielding products, the ones advertising enormous double-digit payouts, often carry the most share-price erosion and the most risk. Before buying any of them, look past the yield and understand the underlying strategy, where the income actually comes from, how concentrated it is, what it costs, and how it has behaved in different markets.

Summary

When the goal is reducing overall investment risk, a historically effective approach has been owning the whole stock market through low-cost ETFs and adjusting your asset allocation, particularly by leaning more on government bonds. Not everyone is comfortable holding the entire market, even paired with bonds, and that's fine. If you're drawn to dividend stocks, it's worth exploring low-volatility and dividend ETFs as an alternative or a complement. And if option income ETFs catch your eye, treat them as the specialized tools they are, not as a simple substitute for a diversified portfolio.

Whatever path you choose, be cautious about chasing high yields, do your research, and remember that past performance is never a guarantee of future returns. As Warren Buffett has long argued, a portfolio of low-cost index funds is often the wiser choice, especially for retirees focused on keeping risk in check.

Next Steps for Your Retirement

Ready to take the next step? I'd love to help you build a retirement plan, investment plan, and tax strategy that fits your comfort with risk.

Visit us at CapitalWealthGroupSC.com to see how we work with the 50-to-60 crowd, and schedule a 30-minute Introductory Call whenever you're ready to dig into your numbers.

Let's make sure you're on the right track for the retirement you want.

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Full Podcast Episode

Welcome to the Retirement Guide Podcast. I'm your host, George Jameson, the owner of Capital Wealth Group, a fee-only advisory firm. Whether you're nearing retirement or already retired, join me each week as we explore the world of retirement planning and equip you with the knowledge and tools you need for a successful retirement.

So let's get started. Today we're diving into the world of dividend stock investing. First off, what exactly are dividends? Well, dividends represent a portion of a company's profits that it chooses to distribute to its shareholders. Many investors prefer dividend stocks because they often appear less risky than the broader stock market. By holding shares in established, well-known companies, you can generate passive income. If you're near retirement or already retired, dividend stocks may seem like an appealing long-term investment. Again, they offer you the option to reinvest or use the dividend as retirement income.

But the question is, is this truly a safer approach to investing? In my opinion, and from all the research that I have done, it may be less risky, but it's not a given. So let me explore this question in more detail. We all know the pros, so let's look at several cons to consider before putting your hard-earned retirement savings into individual dividend stocks:

• First: They are still individual stocks like any other, and that means there's inherent stock risk. You could potentially lose some, all, or a substantial part of your investment.

• Second: By paying out all the cash in dividends, the value of the company is reduced by the amount it paid out.

• Third: Dividends reduce what the company can reinvest for growth.

• Fourth: If you reinvest the dividend in a taxable account, dividends are effectively forced taxation.

• Fifth: If you're a retiree depending on that dividend payment, exposure to a dozen individual stocks for passive income can be risky.

• Sixth: Please note, dividend stocks are not substitutes for bonds.

However, for the right long-term investor, owning a portfolio of low-volatility dividend-paying stocks of well-established companies may make sense. But you have to be aware of individual stock risk, possible sector risk, and from time to time, some of the stocks you own will take a substantial drawdown unrelated to the overall stock market—and at times may drop further than the broader market.

Two key ways to measure dividend stocks are the dividend annual yield and the dividend payout ratio.

• Dividend Annual Yield: Calculated by dividing the dividend per share by the stock price per share. Dividend stocks can range from annual yields of less than 1% up to nearly 10%. Be cautious when considering stocks with excessively high dividends.

• Dividend Payout Ratio: Represents the percentage of a company's earnings paid as dividends to shareholders. A healthy dividend payout ratio typically falls between 30% and 50%. Anything over 50% could be unsustainable.

Here are some other important ratios to consider when investing in individual dividend stocks:

• Dividend coverage ratio

• Free cash flow to equity

• Net debt to EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization)

Just because a company offers a dividend today doesn't mean their stock price can't plummet, or that they won't cut their dividend, or both. Look at the recent poor performance of well-known dividend stocks like Disney, Verizon, AT&T, Target, and Dominion Energy, just to name a few:

• Disney: Down about -51% over a recent two-year period and stopped paying dividends after December 2019.

• Verizon & AT&T: Still paying dividends, but Verizon was down about -20% and AT&T down about -22% over a five-year period (including dividends).

• Target: Down about -47% over a two-year period (including dividends).

• Dominion Energy: Down about -16% over a five-year period versus the XLU Utility ETF, which was up about 39% over the same timeframe (both including dividends).

My point is to show you that most stocks, from time to time, will have dramatic drawdowns. When you only own 20 or so stocks, it can have a substantial negative effect on your overall portfolio.

Personally, I prefer peace of mind knowing I don't have to worry about individual company performance—only the overall market, or a portion of a market's performance if you are trying to reduce volatility. I've noticed that for many nearing or in retirement with substantial investable assets, their main objective is to minimize risk and volatility without a specific focus on keeping up with the overall stock market. They're really more concerned with reducing downside risk. Let's put asset allocation aside for now and just discuss the stock portion of your portfolio.

That's why I'm seeing more and more people choose to either buy individual dividend stocks or hire an advisor who builds a portfolio of individual dividend stocks, thinking this is a more conservative way to invest in stocks than just owning the total market. This may be true, but it's not always the case. The issue is that owning a couple dozen dividend-paying stocks doesn't necessarily mean the portfolio is less volatile or risky, and they may actually be taking on more risk depending on the stocks they own.

Successfully investing in individual stocks is very challenging, which is why I generally suggest looking at ETFs when building your portfolio instead of individual stocks. ETFs typically own at least 50—and often 100 or more—companies in each fund, which makes it much easier to reduce or eliminate individual stock risk (which is the only free lunch in investing). With the development of hundreds of exchange-traded funds, investors and financial advisors now have the opportunity to construct portfolios that align with their goals and preferences, all while maintaining a high degree of diversification compared to holding just a couple dozen individual stocks. Best of all, a lot of these ETFs come with very low expense ratios.

So if you aim to reduce equity volatility and eliminate individual stock risk, investing in a mix of low-volatility and dividend equity ETFs may make sense. You have specific low-volatility ETFs, specific dividend stock ETFs, as well as sector-only ETFs that may make sense for a part of your overall stock allocation. The three main defensive sectors, historically speaking, are consumer staples, utilities, and healthcare. But it's important to note that cherry-picking specific sectors and being too overweight in any one sector can add risk to your overall portfolio.

Per a Morningstar article ("Are Dividend Stocks a Good Investment Today" by David Harrell and Susan Dziubinski), as to whether or not dividends are defensive in practice: it depends. Amy Arnott, a portfolio strategist for Morningstar, looked at six recessionary periods going back to 1980. She found that in three of those periods, dividend stocks outperformed the broad market, and in three, the broad market outperformed dividend stocks. So yes, you think of them as defensive, but not necessarily in all recessionary environments.

In conclusion, when it comes to reducing overall investment risk, a historically effective approach has been owning the entire stock market through low-cost ETFs and adjusting your asset allocation, particularly by increasing your allocation to government bonds. However, it's important to acknowledge that not everyone feels comfortable holding the entire stock market, even when combined with bonds.

For those considering individual dividend stocks, it may be worth exploring low-volatility and dividend ETFs as an alternative or addition. These ETFs include stocks that tend to have lower volatility over the long term while still offering diversification, but it's crucial to exercise caution when chasing high yields, whether in individual stocks or ETFs. Always conduct thorough research regardless of the path you choose.

Ultimately, trying to select individual stocks—even for professionals—can be a challenging endeavor. As Warren Buffett argues, a portfolio comprised of low-cost index funds is often the wiser choice. It's especially important for retirees who often seek to minimize their overall market risk. Whether you opt for low-volatility and dividend ETFs or a portfolio of dividend stocks, they may lower overall risk, though they may underperform the broader market. Always remember: past performance is not a guarantee of future returns, and maintaining a diversified portfolio is important.

Adjusting your asset allocation—especially by increasing your bond allocation—can be an effective strategy to mitigate risk. However, for those inclined to take a more conservative approach and who are less concerned about keeping up with the total market, maintaining a defensive portfolio with low-volatility and dividend ETFs may also be a viable option, offering a balance between risk reduction and long-term returns.

That wraps up today's episode. I hope everyone has a great day!

Thank you for tuning in to this episode of The Retirement Guide. If you enjoyed this episode, please subscribe and leave a five-star review to help others discover the show. For questions, ideas, or to discuss your retirement plan, reach out to me, George Jameson at Capital Wealth Group. If you'd like a free retirement review, visit our website at capitalwealthplan.com to learn more. Thank you for listening. Stay tuned for more insightful retirement planning in future episodes.

And now for the disclaimer: The information discussed in this podcast is for general explanations and education only. It is not tax, legal, or investment advice. Before considering acting on any information heard here, first consult with your tax, legal, or investment advisor. Thank you and have a great day.