Some things get better with age

Some things get better with age. Wine, whiskey, a properly humidified cigar come to mind. In the investment world, there are dividend growth stocks.

I enjoy a high yield as much as the next guy. But focusing exclusively on yield exposes you to the very real risk of losing ground to inflation over time. 

The Fed’s goal is to keep inflation at around 2%. Now, we could split hairs about their calculation methods, and I think it’s fair to say that the “real” inflation rate experienced by most Americans is significantly higher than that. But let’s be generous and pretend the Fed’s 2% inflation target is reality.

Compound Inflation

Like interest, inflation compounds. So, over 10 years at 2% inflation, your purchasing power will decline by 22%. Over 20 years, it’s nearly 50%. 

We’re talking about losing half your purchasing power over 20 years… even under a wildly conservative estimate of inflation. 

So, bonds, preferred stock and high-yield (but no-growth) dividend stocks might pay you a fantastic income stream today. But over the course of a retirement, you run the real risk of having your retirement standard of living degraded.

Realty Income

Now, let’s compare that with a proper dividend growth stock.

Realty Income (O) is a REIT specializing in high-traffic retail. Think the local gas station or pharmacy.

The REIT generally raises its dividend 4% to 5% per year, and it’s working on a string of 89 consecutive quarterly dividends hikes.

Realty Income is not a particularly high yielder at today’s prices. It’s dividend yield is a modest 3.8%. But let’s imagine you bought the REIT five years ago.
Purchasing Power

Your yield on cost (or the annual dividend today divided by your original purchase price) would be a much more attractive 5.7%.

Now let’s pretend you bought Realty Income 10 years ago. Your yield on cost would be a whopping 11.9%.

Now let’s get really crazy and assume you bought Realty Income 20 years ago. Your yield on cost would be a gargantuan 22.4%. 

Takeaway

Yes, you’d be making more than 22 cents per year for every dollar you invested in Realty Income. That’s the power of dividend growth.

I’m not recommending you go run out and buy Realty Income today. Personally, I think the shares are a little too expensive to justify buying with new money. I’d recommend waiting for a significant pullback.

But I bring this up to show you that there’s more to income investing than simply grabbing the highest yield you can find. I even have a name for that. I call it “yield whoring,” and I consider it a vice that’s detrimental to your financial health. 

In my opinion, a good income portfolio should have a mix of high-yielding investments and lower-yielding but faster-growing dividend stocks. Ultimately, I think it’s the only way you’ll stay ahead of inflation in a long retirement.

Photo Credit: Denise Mattox via Flickr Creative Commons