Dividends Can Help Fight Inflation

Last Updated Jun 19, 2009 1:41 PM EDT

While most investors focus on the change in the value of the stock market, dividends have served as an important component of long-term total stock market returns. Because dividends tend to grow over the years, they may serve as a good source of increasing income to help offset the effects of inflation, particularly during your retirement years.

Historically, dividend payments have increased as the companies that pay those dividends grow their businesses and their earnings. While past performance is no guarantee of future returns, a reasonable long term estimate for future dividend growth on a diversified portfolio is about five percent per year.

So if inflation ran at three percent a year, your income stream would be growing at a pace faster than inflation. This means your real purchasing power would be going up over the years.

Here's a quick example to help illustrate the concept:

  • Assume you had a $100,000 portfolio of diversified stocks that paid $2,500 in current dividends. If the dividend payments grew by five percent per year for the next 20 years, the $2,500 in annual dividend payments would grow to about $6,633.
  • If inflation ran at three percent, then the value of the goods and services that you could buy today for $2,500 would cost about $4,515 20 years from now.
  • Since your dividend stream has grown to $6,633, you can actually buy more goods and services on an inflation-adjusted basis.
Fair Odds. While we cannot be sure about dividend growth going forward, the odds are fairly good that over the long term the income stream you receive from stocks will grow as the earnings for these companies grows.

During recessions, some companies do cut dividends, as we've seen over the last year. But once the economy recovers, many of those dividends may be restored. And if you own a highly diversified portfolio, the cuts from some companies can be offset by increases from others.

As with all investment strategies, the potential for dividend growth needs to be assessed over longer cycles. And over longer cycles, it's been pretty reliable. If you're patient, the dividend payments will likely add to your spending power over the years.

Retirement. Potential dividend growth is one reason why even when you're retired, you should consider some stock holdings in your portfolio. It may be uncomfortable to watch the values swing wildly at times, but the long term opportunities for greater income are important in the battle against inflation.

Bottom line. Dividends offer another way to help address the long-term erosion caused by inflation. You should consider them as one piece of your overall strategy to help preserve and grow your wealth.

As with all financial matters, consult your individual advisor prior to making any decisions. The above material is for information and education purposes only.