Choosing stocks for retirement is very different from how most people invest in the stock market: searching for the next Amazon or trying to make some short-term profits.
In the past, financial advisers often considered the stock market too risky for traditional retirement planning, recommending bonds as the main source of income.
The common advice was for the percentage of bonds in the portfolio to be equal to the owner’s age. So, if you were 60 years old, then 60% of your portfolio should be in bonds.
Today, most advisers would probably agree that this structure wouldn’t generate enough retirement income unless the size of the portfolio is really big.
This is because interest rates have been declining for decades. Today, given inflation fears, bonds would hardly provide income.
To build an income stream for your retirement you should focus on stocks. In this article, we’ll review why picking individual stocks are superior to mutual funds and index funds and how to find the best stocks for retirement.
Stocks vs. ETFs, Mutual Funds, and Index Funds
The common ways to invest in the stock market are through mutual funds, index funds, ETFs, and individual stocks.
- Mutual funds are funds sold and managed by investment companies that pick stocks according to various criteria, such as to maximize the return or beat inflation.
- ETFs, or exchange-traded funds, are similar to mutual funds, but they can be bought and sold on an exchange via a broker.
- Index funds could be mutual funds or ETFs that track a collection of stocks included in an index — for example, Dow Jones or the S&P 500, which includes 500 largest public companies.
Index funds are the obvious choice for most investors because these funds represent the stock market as a whole, making it easy to build a diversified portfolio.
Warren Buffett famously recommended simply buying an ETF that tracks the S&P 500 instead of trying to pick stocks. However, as of 2021, tech stocks now have an oversized presence in the S&P 500. Amazon.com (NASDAQ:AMZN), Alphabet (NASDAQ:GOOGL), Facebook (NASDAQ:FB), Microsoft (NASDAQ:MSFT), and other tech stocks now account for up to 20% of the S&P 500.
The S&P 500’s overconcentration on tech stocks, which don’t pay dividends, means that the index on average has a dividend yield of just about 1-2%.
Of course, there are ETFs and mutual funds that are marketed specifically to retirees as “income-focused,” but these come with higher fees and no flexibility. Most importantly, you entrust your future to a handful of managers, who don’t have any “skin in the game.”
Building your own retirement portfolio of individual stocks is cheaper and gives you more flexibility. And with enough diversification, it could be safer than holding an index fund.
Retirement Accounts: Roth IRA vs. Traditional IRA
Before diving into the specifics of finding the best stocks for retirement, you should consider how to set up your retirement account to benefit from lower taxes.
The main two types of IRAs are the traditional IRA and Roth IRA:
- You put pre-tax money in the traditional IRA and pay taxes when you withdraw your money from the retirement account.
- In a Roth IRA, you put in after-tax money and don’t have to pay any taxes when you withdraw income from it.
So, if you think that your future taxes will be higher than your current taxes, a Roth IRA is preferable.
However, there is a limit to who can put money into a Roth IRA and how much you can invest. If you make more than $140,000 a year (or $208,000 as a couple), you can’t contribute to a Roth IRA. And the annual contribution is limited to $6,000, or $7,000 if you are over 50 years old.
How to Choose the Best Stocks for Retirement
As the first step to building a retirement portfolio, think hard about your risk tolerance. If your retirement is still several decades away, you can live with some volatility and boost your nest egg by putting more of the portfolio in growth stocks.
Drawdowns are your biggest risk when investing in growth stocks. A missed quarter or a bad year could easily wipe away 20% of the stock price. And just to recoup that loss, you’d need the stock to go up 25%. That’s why capital preservation is so important.
If you don’t have time to wait out potential drawdowns but have already managed to accumulate decent retirement savings, you should be more conservative and focus your allocation on stocks with dividend yield. Such stocks will provide retirement income for years to come without any active trading on your side.
The best retirement stocks are usually mature companies with well-established businesses that have lower growth rates. Because their businesses are more predictable, they can afford to have clear dividend policies with specified payout ratios. For example, some companies might commit to paying out 50% of their free cash flows.
So how do you evaluate stocks that could be candidates for your portfolio? Ask yourself these four questions when considering a stock for your retirement portfolio.
1. Value Stocks, Income, or Growth Stocks?
Analysts typically categorize stocks as value, growth, or income — based on their equity stories and what they could do for a portfolio.
- Value stocks are “cheap” stocks with low P/E multiples that have the potential to appreciate (that’s Warren Buffett’s original strategy), but there’s a risk that these stocks are cheap because their businesses are declining or being disrupted.
- Growth stocks are fast-growing stocks, especially tech and health care. However, there is usually no clear winner. Competition between companies is fierce. This means that some stocks will underperform. Volatility is the price you pay for this growth.
- Income stocks are the established companies that have strong earning power. They are leaders in their sectors and don’t have to invest as much in increasing or protecting their market shares. As a result, they can afford to pay high dividends and could be considered the best stocks for retirement.
When searching for retirement stocks, you should prioritize income stocks.
2. What Is Its Market Valuation?
Companies are categorized as small cap (less than $2 billion market capitalization), midcap ($2 billion to $10 billion), and large cap (greater than $10 billion).
These numbers aren’t rules, and some might argue that even a $20 billion company might be medium-sized or even small cap compared to giants like Facebook and Amazon.
- Small caps have historically shown better returns. You don’t really need a Ph.D. in finance to understand that smaller companies are more likely to grow bigger than, well, companies that are already huge.
- Large caps, also known as blue chips, are less volatile. These companies are already well-established, and unless they are disrupted by a highly successful startup, they will very likely remain large.
- Midcaps are somewhere in between in terms of volatility and expected returns.
For a retirement portfolio, it is safer to pick from large caps. Yet if you can spend some extra time sifting through smaller stocks, you can uncover some highly attractive opportunities that have both sensible market values and high dividends.
3. What Is Its Track Record of Dividends?
The consistency of dividend payments is crucial when picking stocks for your retirement portfolio. A company that pays a lot one year and skips a dividend entirely the other can’t be counted on to provide a reliable retirement income.
A reliable dividend income also makes it easier for analysts and investors to value a company. In turn, this translates into higher valuations and higher share prices. This also means that dividend yields for these companies would be lower.
For your retirement portfolio, you should seek to find a balance between companies with consistent dividends (and usually lower yields) and cheaper companies that have high yields.
4. Which Sector Is It?
Never keep all your eggs in one basket.
Different sectors of the economy perform differently in various stages of the market cycle.
For example, in a bull market, basic materials (oil, gas, timber, chemicals, etc.) and financial stocks typically grow faster than the market.
And in a bear market, companies that provide staple goods perform better.
You should prepare for all cases and pick your retirement stocks from different sectors.
Some of the best stocks for retirement can be found in:
- Basic materials
- Consumer cyclical
- Consumer noncyclical goods
- Financial services
Basic Materials Stocks With Dividends
Materials stocks usually do well in the beginning of new market cycles. Oil, steel, copper, chemicals, and other commodities are required to build the stuff that other companies produce.
These are the oldest industries, dominated by large companies that can’t really be disrupted by tech startups. These are companies like Rio Tinto (NYSE:RIO), Vale (NYSE:VALE), and Dow Inc. (NYSE:DOW).
Commodity prices could be volatile, and some companies might mess up mergers and acquisitions or take on excessive debt. Yet on average, this sector is stable and has limited growth prospects. As a result, basic materials stocks typically have enough free cash flow to pay dividend yields in the 3-5% range.
Consumer Cyclical Goods Stocks
Consumer companies thrive in bull markets when consumers have the cash to spend. However, when times get tougher and people don’t spend as much, these companies tend to underperform and have to revisit their investment plans.
“Cyclical” goods are things that aren’t necessary and are the easiest categories to save on: cars, new clothes, eating out, home remodeling, and so on.
However, most of these companies have been around for many years and face less pressure from disruptors. They have strong brands and loyal customers that happily return when the economy gets better. And their sizable balance sheets give these companies plenty of dry gunpowder to buy startup brands in emerging niches or using new technologies.
Some companies from this sector are among the so-called Dividend Aristocrats — companies from the S&P 500 index that have at least 25 consecutive years of dividend growth. For example, there are companies like McDonald’s (NYSE:MCD), Target (NYSE:TGT), and Lowe’s Companies (NYSE:LOW).
Dividend yields in this sector vary greatly depending on the market price and are usually between 1.5% and 10%.
Consumer Noncyclical Goods Stocks
There are also some goods that people can’t live without: food, drinks, and home supplies. This sector is called consumer noncyclical goods because demand for these staples does not depend on the economic cycle.
As a result, these stocks are more stable. They have predictable business models. Some of these companies have been around for centuries, surviving through wars, depressions, recessions, and technological disruptions.
These companies typically have reliable dividends. Yet because they are so stable, the valuations are typically high. Dividend yields for these companies are around 1-2%.
Utilities: Classic Dividend Stocks
Besides food, people today can’t live without water, electricity, sewage, and other basic amenities. Companies that provide these services are called the utilities sector.
Utilities are heavily regulated because of the importance of their services and their natural tendencies toward monopolies. Still, they are for-profit companies and pay stable, if somewhat modest, dividends.
Utilities are a defensive play for any portfolio: Their profitability and ability to pay dividends doesn’t depend on the economy. In fact, utilities tend to do better in downturns when interest rates are low because even their lower dividend yields (about 2%) are higher than bond yields.
REITs: Some of the Best Stocks for Retirement
People also always need a roof over their heads. That’s why real estate is a common part of most investment portfolios.
REITs, or real estate investment trusts, are a way to have income from real estate without having to manage any property.
Also, because REITs pool investors’ money, they can buy large properties, such as hotels, office buildings, and warehouses across different geographies. This diversification helps to reduce risks.
Because REITs typically buy large, high-quality properties, they usually don’t have much potential for growth. Yet their appreciation would still at least match inflation while they also pay stable dividends.
REITs pay a dividend yield of 4% on average, although some REITs could have much better yields.
Financial Services Stocks
Debt and insurance payments are another inescapable spending category for most consumers and businesses alike. As a result, financial services stocks could also be a great addition to most retirement portfolios.
Financial services stocks are highly cyclical. They do well when economies are growing and more people and businesses take out loans and use other financial products. But during recessions, they have to decrease their balance sheets and increase provisions for bad debt and credit risks.
Both banks and insurance companies, however, are highly sensitive to interest rates. The current ultra-low interest rates put pressure on banks’ interest margin as well as on insurers ability to earn interest from their portfolios that they tend to keep mostly in bonds.
Because of their cyclical nature, share prices of banks and other financial services companies are more volatile than many other sectors. Yet when share prices are down, there could be some opportunities to grab double-digit dividend yields.
Build Your Portfolio With the Best Stocks for Retirement
We’ve covered a lot of ground — how to look at stocks when building a retirement portfolio, and which sectors to consider and why.
Selecting dividend-paying stocks from a range of sectors and industries is a great way to build a diversified portfolio that provides retirement income.
To find some of the best stocks for retirement and enjoy high dividends, subscribe to Investors Alley’s “Dividend Hunter” newsletter.