Inflation is a Swindler
A swindler is a crook or embezzler. Oftentimes when things are stolen, you may not know the extent of the loss until some time has passed. When we moved from Milwaukee to Fitchburg in 1999, some things did not make it from our home in Milwaukee to our new home. It is likely that a box or two of our belongings were taken from the yard as the movers were doing their work. Even today we are not certain what was taken, but there are some things where I think of something that is gone. Bonds, during the stealthy or rapid climb of inflation, do a similar thing to an investor. Inflation steals buying power.
Warren Buffett said, “Inflation swindles the bond investor … it swindles the person who keeps their cash under their mattress, it swindles almost everybody.” Thankfully, when it comes to the types of investments you choose, you do have a choice. While it is true that there is no risk-free investment, if you understand the differences between risk and volatility you are likely to come to different conclusions.
The Problems with Bonds
When you purchase a bond, you are loaning money to the bank, municipal government, the Federal government or to some other type of business. For every $1,000 you lend, you are guaranteed a set rate of return. However, you really aren’t receiving a guarantee. You are put in the front of the line ahead of stockholders, so you will receive your interest before a stockholder would receive their dividends, if any.
If you are promised 5% on a $1,000 bond, you should expect to receive $50 per year. That is certainly better than 0.02% interest on a savings account or a CD. However, as the Federal Reserve hikes interest rates, bond owners will start to sell their bonds because they see more safety in FDIC insured accounts. If many bond holders do this, and they do, the price of the bond will drop. Therefore, your $1,000 can quickly turn into $900. You might take comfort in the fact that you will still (hopefully) receive your $50 every year, but at what cost? You see, inflation will make your $50 worth more like $47 in no time at all.
Getting My Money Back and Inflation
But, you say, “a bond is better because at maturity I will get my $1,000 returned to me by the borrower.” Yes, you will. If the bond, however, matures in five years, your $1,000 is worth much less than $1,000 when you factor in inflation. You are getting dollars that are worth less than they were when you loaned them to the bond issuing entity. So while it is usually true that you don’t have to sell your bond when the value sinks, you won’t really get the same value back at the end of the bond’s life. Assuming 3% annual inflation for five years, a five-year bond makes your $1,000 worth less than $900.
Furthermore, realize that the entity that sold you the bond thinks they can make more money with your money than they are paying you and that they can also repay you in cheaper dollars. If you understand that and still like bonds, at least you are entering the swindle with knowledge.
According to Reuters, “Inflation has surged in the United States, hitting a new 40-year annualized high of 6.6% in March, and U.S. Federal Reserve policymakers appear set to deliver a series of aggressive interest rate hikes to cool prices.” Reuters, April 30, 2022
Why Dividend Growth Stocks Are My Favorite
I prefer to stay one step ahead of a swindler. The primary method I use is to buy dividend growth stocks and ETFs. The secondary solution is to own BDCs and REITs that pay a monthly or quarterly dividend that has a better yield than most “safe” bonds. There is risk with this approach. But there are benefits.
One of the benefits of the dividend growth strategy is that companies with a track record of increasing their dividend year-after-year really don’t want to reduce or suspend their dividend. Therefore, the company board desires to under promise and over-deliver to the stockholders. The way they do this is by having a dividend payout ratio that makes sense given the company’s projected revenue, income, and profit growth.
A general rule of thumb for most dividend stocks is to look for a payout ratio of 20-70%. There are exceptions for utilities, REITs, and BDCs. Some investments pay based on FFO (Funds from Operations.) The FFO-per-share ratio should be used in lieu of earnings per share (EPS) when evaluating REITs and other similar investment trusts.
Dividends in a Bear Market
Most dividend payments will continue to arrive even when the stock market is going down in a correction, or a bear market. Therefore, as the price of the investment goes down, the yield increases, making the investment even more attractive to the dividend-focused investor. This has an effect on the price of the shares. Most dividend investors don’t sell their investments in a panic. Because of supply and demand, the prices on dividend growth stocks tends to be less likely to drop as fast and as far as pure growth stocks.
Think of it this way: If I want to buy groceries, I can either work, receive Social Security, trade stock options, or have income from bonds and stocks. If I need more than that, I have to sell an investment to raise the cash or sell something I own that someone wants. However, if I have a strong flow of increasing income from dividends, selling becomes far less likely.
Dividends and the IRA Required Minimum Distribution (RMD)
During bear markets I have never had a situation where selling anything was necessary. Furthermore, when I have to start taking my RMDs from my traditional IRA, I won’t have to sell investments to take the RMD. The dividends being paid by my stocks in the IRA are more than sufficient to meet the need. Therefore, I don’t have to sell an investment at a reduced price during a bear market to meet the RMD obligation.
Bonds cannot and will not rescue you from the inflation swindler. Dividend growth stocks have a far better capacity to avoid and even beat that swindle.
Funds From Operations
This is a helpful link to understand FFO. LINK
“Inflation swindles the bond investor … it swindles the person who keeps their cash under their mattress, it swindles almost everybody,” Buffett said. See the following link for the source of this quote. LINK