Inflation can erode your purchasing power over time, especially if you're on a fixed income. Carefully selected dividend stocks can provide a hedge against inflation by generating a rising income stream while appreciating in value.
Many companies in mature industries such as utilities or financials pay dividends. Dividend yields can vary anywhere from 1 to over 10 percent. High-dividend-yielding stocks can provide a good income stream, but are not likely to protect you against inflation if the dividend amount remains the same.
Some companies increase dividends over time. Dividend increases can provide excellent protection against inflation in the long run. For example, you buy 1,000 shares of XYZ for $30 a share, which pays a 50 cent a share dividend, so you stand to collect $500 in annual dividend income. Next year, consumer prices increase 3 percent -- an item that cost $500 now sells for $503. But your XYZ stock boosts the dividend by 10 percent to $550, which puts you $47 ahead.
Yield vs. Growth
Dividend yield shows you how much you stand to collect in income on your investment now; dividend growth shows how much the income has increased. Generally, the higher the current dividend yield, the lower the dividend growth. You can find stocks yielding 5 or 8 percent, but most stocks that increase dividends yield much less, typically 1 to 3 percent, so you must choose whether you want to collect more income now or ensure a rising income stream in the future.
Stock Price Appreciation
Since dividends are paid out of company profits, a company can raise dividend consistently only if its earnings rise. Stocks that increase dividends as their earnings grow also tend to appreciate in price. In our example, XYZ dividend yield is 1.67 percent, but if next year, XYZ boosts its dividend 10 percent because its earnings grew 10 percent, its stock price could increase to $33. The yield will remain the same, but the amount of income and the value of your shares will increase. Rising stock prices would provide an additional hedge against inflation.
Not all stocks pay dividends, and not all dividend stocks increase dividends. Dividends, and more so dividend increases, are not guaranteed and can stop at any time. The stocks of companies that cut or eliminate dividends often fall. It takes a considerable amount of work to build and maintain a portfolio of stocks that increase dividends over time. If you don’t have the time or inclination, you may want to go with a mutual or exchange-traded fund that invests in dividend growers.
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