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Are dividend shares a good way to protect yourself in a recession? If not, why not?

Yes and no. Dividends themselves will not protect your principal investment. If there is a recession or a panic selling, your stocks will lose value. There is no protection except going 100% cash. But that is tricky because no one will ever know when the recession started until we are in one deep to our eyeballs. And going full cash at that moment is usually too late already. So the best way is to stay invested during recessions and if possible keep buying more shares.

What the dividends can however do for you (unlike the growth stocks) is to guarantee your income. So there is a difference between buying growth stocks and dividend stocks and that difference is the reason why I use dividend stocks over growth stocks.

And the difference is that even during recessions, your dividend stock will keep paying you your dividends. And if you build a portfolio over time made of dividend stocks paying you enough every year so you will never have to sell a single share of your stocks, then you do not have to worry about the value of your stocks. If you never have to sell, who cares if your portfolio loses 50% or even 70% of your value?

There are two strategies how people can save for retirement – a 4% rule (peddled by current financial advisers) and a sole dividend income.
The 4% rule means, that every year you sell 4% of your portfolio and use the cash for your daily expenses. So if you have a portfolio of, let’s say $1 million you will be selling $40,000 annually for your retirement (and if you need more than that, let’s say $60,000 every year, you need to save more) and hope that during the next year your stocks grow more and make up for your next year withdrawal (because after your first year withdrawal, you will only have $960,000 in your account).
But let’s say the very second year a recession hits the market and your portfolio drops 60%. Now your $960,000 portfolio is worth only $384,000. And since recessions and bear markets usually last 1.5 to 2 years (sometimes a bit longer) at the end of the second year you will be taking $40,000 out of your $384,000 leaving you with $344,000 to start a year three. Ouch. That is pretty much an end of the game and a sure ticket to go back to work.

On the other hand a dividend growth stocks can provide you a protection of your income; not your portfolio, but your income.

If you start building up your portfolio when you are 20 years old and save $1,000,000 then your YOC (yield on cost) on your stocks will be around 15% to 20% (depending on the stock selection and dividend growth). But let’s stay conservative and say that your YOC will be only 6%. And 6% annually from your $1 million stock holdings will be $60,000. Yes you will receive $60,000 every year no matter what is happening. If a recession hits and your portfolio shrinks down to $384,000 you still will receive your $60,000 annually and you do not have to sell a single share. And 6% is a very achievable rate. As I mentioned above, over 25 or 30 years, your actual yield will be a lot higher due to the dividend growth as every company increases the dividend every year. For example, Johnson & Johnson (JNJ) paid dividend for the last 100 years and increased the dividend for the last 50 consecutive years, Coca Cola (KO) increased dividends for the last 57 consecutive years, McDonalds for 44 consecutive years, etc. There is currently 138 high quality dividend growth stocks (aristocrats) which were paying dividends for more than 50 years and increased them every year for more than 50 years. Even during 2008 recession these companies increased their dividends.

And these are the stocks you want in your portfolio because they will protect your income. They will not protect your portfolio value (to some extend) but with these stock, you can let your portfolio drop by 50% or even 70% and you wouldn’t have to move a finger and you would be comfortable waiting the storm out and in two to three years your portfolio recovers.

There is another aspect to the dividend stocks. They tend to grow at the same rate as their dividend. So if a company increases the dividend 3% every year, you may expect the stock price to increase by 3% that year too. For example, I was buying JNJ stock when everyone was selling it during the panic. My average cost basis is $48 a share. Today, the stock is trading at $147 a share. Even if it loses 70% of its value during the next recession, it will be trading at $44 a share. I will be pretty much break even on the value of my holding but on top of that, I will still keep receiving my nice fat dividend (currently my YOC is 20%). And guess what I will be doing if this stock loses 70% of its value? You guess it, I will be buying like crazy!

And that is the big difference between growth stocks and dividend stocks and how dividend stocks can protect you and help you to weather out recessions.
Of course, there is another important aspect to dividend investing – you must pick high quality dividend growth stocks. On my blog, I have a list of the dividend aristocrats (champions) updated every month (note: the list was originally created by David Fish and now when he passed away the list is maintained by one of his followers Justin Law). Here is a link: Dividend Growth Stocks CCC list.

If you keep buying shares from that list (and sell when they are removed from the list) your portfolio will be well invested and your income well protected.

1 response to “Are dividend shares a good way to protect yourself in a recession? If not, why not?”

  1. Scott says:

    Love this post. That’s my ultimate goal too, to be able to have a large enough portfolio that the passive income that it generates is more than enough to cover the annual cash needs. That will allow me to keep the majority of the money invested and allow it to compound over an even larger timeframe.

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