3. Dividend-rich stocks How they work: As a rule, public companies either reinvest earnings or pass them along to shareholders as dividends. For individuals looking for a hedge against inflation, the second variety is hard to beat. That's because dividend-rich stocks provide income, but unlike fixed-income investments, they have the potential for capital growth as well.
Large, established stocks, such as those in the Standard & Poor's 500, have a greater likelihood of offering dividends. Nearly 80 percent of the index's constituents pay cash dividends, versus just 39 percent of companies not listed on that index. Those paying the highest dividends are generally found in such sectors as industrials, utilities, financial services, pharmaceuticals and consumer staples.
Cost: Share prices vary depending on the company and market conditions. A commission is involved with the purchase of stocks, whether you purchase through a full-service brokerage firm or you're a self-directed investor. Costs will be lower for the latter type of firm. If you buy a diversified mutual fund that focuses on dividend-rich stocks, you'll pay an expense ratio.
Liquidity: Very liquid, in theory. You can buy or sell any dividend-paying equities at any time; however to reap lower tax benefits of qualified dividend distributions, individuals generally must own equities for a certain amount of time. That's generally more than 60 days in a 121-day period surrounding the so-called ex-dividend date, which is the day after shareholders who are entitled to a dividend are identified.
"In other words," says Mark Luscombe, principal tax analyst at CCH, "you can't just buy the stock immediately before the record date and sell it after and expect the dividend to qualify for capital gain treatment."
Pros: Low taxes -- for now. Until 2010, qualified dividends are subject to capital gains taxes, which are no higher than 15 percent for individuals in tax brackets 25 percent or higher. (Individuals in lower tax brackets owe no tax on dividends starting in 2008 until Jan. 1, 2011.) Note: Nonqualified dividends -- from REITs and preferred stock, for example -- are subject to income taxes at ordinary rates. But generally, stock dividends are cheaper from a tax standpoint than income from bonds or TIPS.
The potential for capital appreciation with dividend-paying stocks, versus, say, the fixed value of a bond, means that these equities have the potential to keep pace with, or even surpass, inflation, while also providing a steady stream of income.
Cons: Besides the potential for capital loss, these stocks generally lack diversity. Dividend-paying stocks, or funds that invest in them, tend to concentrate on a few industries that aren't known for rapid growth.
Risks: Equities can lose money, so buying dividend-rich stocks requires homework. "You have to be careful and do fundamental research because there are some really lousy companies that have big dividend yields," says Christine Benz, director of personal finance at Morningstar.
If you're leery about making a bad pick, consider turning to mutual funds that focus on dividends, such as Vanguard Equity Income or T. Rowe Price Equity Income. Warning: The performance of mutual funds is not guaranteed either, and values can go up or down.
Who they're good for: Most retirees need the potential growth of equities, whether they pay dividends or not. After all, says Benz: "For someone who's retired and will be living for another 20 years to 25 years, the risk of running out of money far outweighs the day-to-day volatility" of equities. But as seniors leave the work force, the added bonus of dividends is a smart choice for individuals who will need assets that provide both growth and income.