Why Dividends Protect More Than Capital Gains

Includes: ABT, JNJ, PG
by: Pey Shadzi

A few days ago I did my best to unwind after a particularly stressful work week. A few stories up on the balcony of my San Diego apartment, I watched a beautiful red sunset slowly fade off into the western sky while sipping the last few remaining ounces of some incredible local San Diego beer from a snifter glass. Needless to say, I did my best to remember how incredibly lucky I am. With complete honesty, I consider myself one of the most fortunate people in the world. Sure, work can be stressful from time to time, but it's always important to remember the bigger picture.

Am I right or am I right?

Living legend Warren Buffett claims he is literally one of the luckiest people in the world for winning what he refers to as the "ovarian lottery." For those of you who may not worship Buffett as much as I do, please allow me to explain. Buffett argues that being born Caucasian in America during the 1930s, along with being "ideally wired for the system" while having an "above-average ability to allocate capital," allowed him to create extraordinary profits over the course of his lifetime. Though it's fairly obvious most people in America would kill to be Buffett, how many do you think realize how lucky they actually are to have been born in America? Or to have food or running water for that matter? Sometimes it helps to look at the world through a different lens.

Realistically, though, that line of positive thinking won't necessarily help us out when we're down on our luck, not able to pay our mortgage or put food on the table for our families. Feeling lucky won't solve our problems in the event we're laid off from work and stress levels are running at an all-time high. Everything is relative and it's always difficult to see the bright side of being born into a "life of opportunity" when our future quality of life doesn't look so rosy.

You see, despite being a young guy, I've watched my dividends roll in over the course of the last few years from blue chips like Johnson & Johnson (NYSE:JNJ), Abbott Laboratories (NYSE:ABT) and Procter & Gamble (NYSE:PG). After realizing these are essentially streams of income I'm using to build more wealth, I've allowed myself to potentially change my mindset from being "discretionary investment income" to "necessary income" in the event something happened to go awry in my life. Quite frankly, dividends that roll in faithfully each and every quarter from reliable companies don't necessarily need to be reinvested. I mean, what happens if I run into some trouble? What if I'm unable to pay my mortgage, put food on the table or fill up my gas tank in order to make it to work every morning? Enter those glorious quarterly cash payments called dividends to save the day.

How dividends differ from capital gains.

For retired folk planning to "spend down" their retirement portfolios, they often rely on selling shares of mutual funds or collecting their dividends in order to provide income in retirement. But quite frankly I'm at least 35 years away from retirement. In the event I run into some hardships with my place of employment and happen to be laid off from work and require income for some time, why not choose dividends to help me make it through these tough times rather than accumulating credit card debt or having to foreclose on my home? In this respect, a constant stream of quarterly dividends could potentially replace a significant portion of an income stream. It certainly deserves some consideration, wouldn't you agree?

But I could always just sell some stocks...

Of course, you're always free to sell shares of stocks in order to provide a capital stream to pay bills. But what if we happen to be in a recession much like we experienced in 2008? The amount of capital received from selling shares would wipe out a much larger portion of your account balance over the long term, leaving you with less shares to reap the benefits of a potential recovery. If an exciting bull market were to ensue, an investor would miss out on the potential gains after selling shares of stocks to cover expenses. But what about dividends? As it turns out, companies like Johnson & Johnson, Abbott Laboratories and Procter & Gamble never suspended dividends during the last recession. They continued to increase annual payouts to shareholders who have faithfully held on during both bull and bear markets.

Dividends will help get you through.

Of course, using dividends to supplement your income requires a fairly significant account balance if you're looking to replace your whole paycheck. However, with that said, in the event of misfortune, switching your dividend reinvestment methods to cash disbursements could potentially help protect you when life throws you an unexpected curve ball. At the very least, holding a portion of dividend stocks in a portfolio as a safety net, along with an emergency fund for those rainy days, could potentially save an investor during significant hardship. And if that hardship never happens to materialize, dividends from faithful blue-chip companies will likely still roll in every quarter. Think about it: Who wouldn't want to collect this stream of cash for reinvestment when times are good?

Here's the bottom line:

An investor's decision to purchase stocks with a capital appreciation focus or a dividend-payment mantra is incredibly individual. Perhaps you're a tenured professor with a secure job. Maybe you've been able to build up a 12-month emergency fund to get you through those rough times. For me, however, I'll continue to build up my dividend-payers in order to potentially replace my paycheck in the event I run into hardship down the road. Hopefully one day this stream of dividends may fully replace my current income stream. Until then, though, I'll likely use this account as a backup in case I run into an unfortunate financial situation sometime in the future.

Think I'm wrong? Do you think growth stocks are superior to dividends when facing hard times? Feel free to let me know in the comment section below.

Disclosure: I am long JNJ, ABT, PG.

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