Excerpted from Bogle on Mutual Funds by John C. Bogle, pages 34-36

Many investors do not give much thought to income generation until after they reach retirement. Then they seek not only a reasonable level of income, but income that tends to increase steadily over time. Of our three asset classes, only common stocks - by growing their dividends - can deliver this dual objective. Of course, by investing in common stocks you assume the risk that dividends will decline during periods of recession or depression - sharply, as during the early 1930s, or more moderately, as from 1941 to 1943.

What is truly remarkable is that the record of dividend payments by U.S. corporations heavily favors rising dividends over declining dividends, almost irrespective of prevailing business conditions. Using the 1926-92 base period, annual dividends increased in 57 years, declined moderately (less than 10%) in four years, and declined by more than 10% in another five years. In one year, dividends were unchanged. On average, dividends increased at an annual rate of +4.5% since 1926, nicely exceeding the inflation rate of 3.1%, resulting in real income growth of +1.4% per year. The relationship has been particularly strong since 1950, as Figure 2-4 shows.

Barring some sort of unforeseen depression or financial catastrophe (a possibility we cannot ignore), I think it is fair to conclude that income risk in stocks is generally modest. That conclusion, sadly, is only part of the story. For it has often happened that the price paid for $1 of dividends may be so exorbitant that it could take many years for even steadily growing dividends to catch up with the equivalent total income you could earn by purchasing a bond. As I showed in Figure 1-3 in Chapter 1, it makes a big difference whether you pay $40 or $10 for each $1 of dividends.


Figure 2-5 compares the returns of two income-oriented investors who have a choice between investing $10,000 in (1) a diversified stock portfolio yielding 3% but with income growing at 6% annually or (2) a long-term bond yielding 7%. The investor who selects the stock portfolio receives less than half of the annual income of the bond investor at the outset. Only after 15 years does the annual dividend on the stock portfolio reach the level of the annual interest payment from the bond, and only after 26 years are the cumulative income streams of the two investments equal.


We know from Chapter 1 that the income risk in stocks is far more likely to be accounted for by paying too high a price for the dividends in the first place than by declining dividends. Unfortunately, defining what constitutes too high a price for dividends is a fallible exercise, one that must take into account not only the average historical valuations for stocks but the current valuations for other investment alternatives as well. History suggests that stocks are relatively expensive when the price paid for $1 of dividends is above $30 (i.e., a yield of 3.3%) and relatively cheap when the price paid is less than $20 (a yield of 5%). However, stocks may well be attractive at a yield of, say, 3.5% if there are compelling reasons to assume that their dividends will increase rapidly or if yields on other classes of financial assets are relatively unattractive.

YAHOO! FINANCE TIP Yahoo! Finance reports a company's P/E and yield data on its key statistics page. For an example, see GE's key statistics page.

In the example shown in Figure 2-5, buying a portfolio of stocks at a 3% yield rather than a bond at a 7% yield might not be a sensible investment, especially considering the incremental risk incurred in holding stocks. When stocks yield 4.5% and bonds yield 6%, that may be quite another story.