Remember when everyday products were much cheaper than they are
now? That's a real-life example of inflation, an unavoidable
phenomenon that erodes the value of money by pushing prices up over
time. If capital isn't being put to work and making a return during
inflationary periods, the purchasing power of investor capital is
Investors have a wide range of tools at their disposal to help
protect their portfolios from the ravages of inflation. Some prefer
inflation-protected bonds, while others swear by commodities such
as gold as effective inflation hedges. Investing in dividend-paying
stocks is one of the best ways to offset, or even outpace,
inflation's degenerative effects on one's savings.
Dividends and Inflation
While placing money in a savings account may seem like the
safest investment, banks don't pay nearly enough interest these
days to compensate investors for inflation. In fact, interest rates
are at record low levels, making now one of the worst times in
history to let money sit in a savings or money market account (that
goes for CDs too). Thus, savings are eroded in terms of future
buying power, as product prices creep up over the long-term.
Dividends are payments made by some companies to shareholders,
usually on a quarterly basis, which give investors a tangible
return on their investment for as long as they own the stock and
dividends are paid out.
Dividends are a tangible return, in that investors receive the
payment while holding the stock. Capital returns - gains attained
from selling the stock for more than the purchase price - require
that the stock is sold and therefore the actual gain is not known
until the actual sale occurs. Therefore, dividends are a great tool
for determining if yearly dividend receipts more than offset the
rise in consumer goods due to inflation.
Inflation is expressed as a percentage figure over a period of
time. For example, according to governmental data, the inflation
rate in 2011 was 3.16%. This means the cost of a basket of consumer
goods, also called the Consumer Price Index (
), increased by 3.16% in 2011.
Dividends can also be expressed as a percentage, called the
"dividend yield." Calculate a stock's dividend yield by dividing
total dividends in a year by the current stock price. For example,
if $2 in dividends are paid out per year, and the current stock
price is $50, the dividend yield is 4%. If the inflation rate in
that year is below 4%, the dividend yield has outpaced the negative
effects inflation. If inflation is more than 4%, the dividends will
only partially offset inflation.
Aside from providing a hedge against inflation, dividends also
contribute largely to overall portfolio returns. Between 1926 and
2010 the S&P 500 returned 9.9% per year (compounded), and 3.96%
of that total return came from dividends - more than 40% of the
Partial Inflation Hedge
The average dividend yield for stocks within the S&P 500
index provides a benchmark yield investors are likely to receive
for holding a basket of dividend stocks. At times, the average will
outpace inflation, while at other times it may not.
In January of 2009 the S&P 500 dividend yield was 3.24%,
while inflation throughout 2009 was -0.34%. Not only did the
dividend yield outpace inflation, but the S&P 500 also
appreciated 23.45% that year. That type of dividend yield
performance, relative to inflation, does not always occur.
From January 1992 through January 2012, the S&P 500 average
dividend yield managed to outpace inflation in several years. In
most of those years though, the average dividend yield acted as a
partial hedge, only offsetting a portion of the inflation rate.
Figure 1. Inflation (%) Vs. Dividend Yields (%) - January 1
Keep in mind the dividend yield does not account for capital
gains or losses, and only reflects the return from dividends.
Through the 20-year period depicted above, dividend yields were an
effective partial hedge against inflation; however, it is possible
to do better.
It is possible to outpace inflation by selecting higher yielding
dividend stocks, but investors should still be aware of value
traps. The average dividend yield of the S&P 500 index is just
that-an average. The dividend yield on an individual stock can vary
greatly from that average, providing the capability to outpace
For example, consider Dominion Resources (
), part of the S&P 500. From 2003 to the start of 2012 the
stock outpaced inflation in all but one year.
Figure 2. Inflation (%) vs. Dominion Resource Dividend Yield (%)
- January 1 Numbers
Over the same timeframe, the dividend yield of Ventas Inc (
) also outpaced inflation consistently.
Figure 3. Inflation (%) vs. Ventas Dividend Yield (%) -January 1
By focusing on higher dividend yielding stocks it is possible to
outpace inflation over the short and longer terms. This will at
times require exchanging one dividend stock for another, as
dividend yields and inflation both fluctuate constantly.
While the dividend yield provides a gauge to determine how a
stock is performing relative to inflation, the overall price
direction of the stock is also important. If the stock price is
continually falling, the high dividend is likely being offset by
capital losses. Therefore, also determine the soundness of the
company and the stock's price stability before buying a stock
simply because it has a high dividend yield capable of outpacing
The Bottom Line
Dividend stocks provide a great partial hedge against inflation,
providing a tangible return and cash flow to the shareholder. By
selecting individual stocks with higher dividend yields - but that
are still stable companies - it is also possible to significantly
outpace inflation. Since dividend yields and inflation are in
constant flux, it is sometimes necessary to exchange one stock (or
several) for another in order to continue outpacing inflation. In
certain years, inflation may win, but over the long-term, by
consistently picking high quality dividend stocks, it is possible
to generate a higher yield than inflation.
Be sure to visit our complete recommended list of the
Best Dividend Stocks
, as well as a detailed explanation of
our ratings system here