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The Benefits of Including Stocks in Your Portfolio

By Rick Imhoff, CFP ®

Investors are once again having to deal with very low interest rates.  This can be particularly frustrating for investors who focus only on fixed-income investments for their portfolios.  Currently, it is a struggle to find a rate over .5% unless you are willing to extend your maturity for about 5 years or more to even get 1%. 

If you are focused on income, there are several stocks paying a much higher dividend yield than the interest rate on high quality fixed-income securities.  For example, Verizon has a dividend yield of 4.26%, US Bank 3.97%, Wal-Mart 1.78%, Caterpillar 3.05%, Johnson & Johnson 2.74%, and Pepsi 3.09%.  This is not an endorsement or recommendation to buy these stocks, but rather to provide an example of why consideration should be given to include stocks as part of the asset allocation in your portfolio.

First off, the yield is considerably higher than the yields offered on high quality fixed-income securities.  Just by carving out 30% of your portfolio to invest in large cap, high quality stocks with a history of paying dividends, you could potentially increase your cash flow by 50-75% over current rates on high quality fixed-income securities.

Secondly, in a taxable portfolio, you would pay income tax at ordinary rates on any interest earned on taxable fixed-income securities.  Depending on your tax bracket, that could reduce that small yield even more after taxes.  Qualified dividends from most stocks are taxed at the long-term capital gains rate.  This means if your income is $40,000 or less for a single filer, or $80,000 or less if you are married and filing joint, the tax rate on the qualifying dividends would be zero.  If your income is over those amounts, then you would only pay at a 15% rate, which would be below the ordinary income tax rate of 22-35%.  So not only do you receive a higher cash flow, you get to keep more of it after taxes.

Finally, the stock price might increase over time.  No tax is due on the gain unless you sell the stock.  If you do, you again pay only the long-term capital gains tax rate, which is typically 0% or 15% for most taxpayers.  But what if the stock falls in price?  This may be a temporary decline, but if you chose to sell the stock for less than you paid for it, you can realize the loss.  At the end of the tax year, you add up all your realized capital gains and losses and if you realized more losses than gains, you can deduct up to $3,000 of the net loss in the current tax year and carry forward any excess realized losses into the next calendar year and subsequent years as necessary.  The loss would help to lower your other taxable income, reducing your income tax liability.

These tax benefits do not apply if part or all your portfolio is in a Traditional IRA, Roth IRA, 401(k) plan, or Health Savings Accounts as these accounts offer either tax deferral or tax-free accumulation of your money.  However, the benefits of the higher yields and potential for capital appreciation still apply.  

Of course, all this would depend on your risk tolerance and time horizon.  If you have a short time horizon, meaning you will need your money within the next 5 years, it may be best not to invest in stocks.  If you do not think you will need the money for 10 years or more, then you probably would be fine.  The longer your time horizon, the greater the chance your stocks will have a positive rate of return, at least based on historical broad market averages like the S&P 500 Stock Index.  Keep in mind that just because you are retired does not mean you have a short time horizon.  Planning on 20+ years would be prudent when considering your overall asset allocation decision.