John Bogle made an interesting point related to investing for income in his book Common Sense on Mutual Funds, written in 1998.
I'm reading the Fully Updated 10th Anniversary Edition (somehow I missed it for ten years), which is interesting because instead of updating the original text, he leaves the original text and graphics, and then adds 2009 updates in red, so you know he hasn't messed around with his original data or conclusions.
I'm sure it'd be tempting for any author revising a book a ten years later, to -- ahem! -- edit out select statements that didn't quite worked out. Did I really write THAT? Nobody in 2010 wants to read that now.
The 1998 Market Was a Lot Different Than This Market
To his credit, Bogle takes the lumps of time as well as the rewards for having been right, and he was right more often than wrong. The updates are usually most interesting because the original was written during the height of the dot com boom, and the updates are Bogle writing after ten years of a brutal stock market, in the middle of a recession and financial crisis.
Anyway, one section discusses whether the market in 1998 is overvalued based on dividends. He contends that stock dividends are one factor for the market price, because they're one way investors are rewarded for owning stock.
When the Bull Runs, Stock Dividend Yields Fall
He notes that at the start of the bull market in 1982, $1 of dividends required a stock price of $16, which means the yield was 6%. As of the time he wrote the book in 1998, $1 of dividends cost $71, which means the yield was 1.4%.
He ends by writing that if $71 is not too high a price to pay for $1 in dividends, there must be some price that is too high to pay.
His update notes that by early 2000 the price for $1 in dividends was $99, but by 2009 it was back down to $38, which is a yield of 2.63%. That's due partly to the trend for dividends to go up, and because the market prices of stocks have gone down.
As I write this in July 2010, the market is up, and the average yield of the S&P 500 is now 1.85%, meaning you now have to pay $54 for $1 in dividends.
How Low is Too Low?
I had to stop and think. It's certainly true SOME price is too high to pay for $1 in dividends. What is it? Let's face it -- back in 1982 we'd have screamed to have to pay the current price of $54.
So partly it depends on what the alternative is.
If money market funds paid 1.85%, then stocks would seem to be a poor choice. However, right now money market fund interest rates are running about 0.75%, so they're even lower.
And there's the issue of dividend growth. Bonds pay the same interest rate over their entire life, which makes them better for current income but vulnerable to inflation.
$54 would be crazy to pay for dividends if you weren't going to receive your money back for 54 years. However, stock dividends grow over time. How much exactly can't be predicted of course, but the dividends you buy today won't take as long as 54 years to reimburse you. If that were true, you'd still be better off keeping your cash in a money market account.
Also, that yield is the S&P 500 as a whole. Many of those companies don't pay any dividends. If you bought only the S&P 500 companies that actually pay dividends, your average yield would be 2.5%, costing $40 -- almost as low as the entire S&P 500 in 1982.
Stock Dividends Grow in Time, Making Them More Valuable the Longer You Own Them
However, you can do better than that. You can focus on the stocks that pay the highest yields. You can focus on the stocks that have a long history of raising their dividends every year. You can buy particular kinds of stocks that for legal reasons pay higher dividends than ordinary companies. Also, some stock markets in the world may have companies that pay dividends but cost less than US stocks.
If the price of stocks and bonds ever does go so high that they're too expense, then hang on to cash in a money market, and wait. Sooner or later, their price will go down. That's what happened with the market Bogle was writing about in 1998.
When you're investing for income you don't have to depend on the S&P 500. You can pick and choose from the entire world.
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