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It's Time to Fine-Tune Dividend Holdings

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For dividend investors, it's time to get picky. Investors focused on stocks paying regular dividends have lately reaped a bountiful harvest. But investors who snap up dividend payers indiscriminately—or load up on the highest-yielding stocks they can find—may find themselves with some rotten apples. Rising interest rates may hurt some types of dividend-paying stocks far more than others—and some of the most traditional dividend-paying sectors, such as utilities and telecom services, are likely to feel much of the pain, money managers and analysts say.

See Also: It's Time to Fine-Tune Dividend Holdings

And while financial firms have rolled out a host of new dividend-focused mutual funds and exchange-traded funds, investors should tread carefully. They must scrutinize the funds' strategies and portfolios to be sure they're not overloading on overvalued dividend sectors that are poised for a fall.

Investors may be reluctant to tweak their dividend portfolios at a time when payouts are looking more generous. Among companies in Standard & Poor's 500-stock index, dividend payments in the first half of this year jumped about 14% over the first six months of 2012, with further growth projected in the second half of 2013. And 82% of companies in the S&P 500 pay dividends, the highest level in nearly 14 years.

Although older investors may need to get more selective, they can remain confident in dividend stocks' benefits for retirement portfolios. For portfolios in drawdown mode, high-quality dividend stocks can provide steady and growing income as well as the potential for capital appreciation and a shield against inflation. The long-term returns of dividend payers have beaten the broader market with lower volatility. Between 1926 and 2012, dividends accounted for 42% of the S&P 500's total return.

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Some retirees find that a well-curated collection of dividend payers helps them cover retirement expenses while largely ignoring the market's ups and downs. Bruce Miller, 62, of Vancouver, Wash., started building his portfolio of dividend payers soon after retiring from the Air Force in 1999. He looks for companies that have at least a ten-year track record of paying dividends, a dividend growth rate of at least 5% per year and cash flow amounting to at least 150% of the payout.

Miller's favorites include consumer-product makers such as Clorox and Kimberly-Clark. While a military pension covers most of his basic expenses, Miller finds steady dividends a reliable way to maintain his lifestyle, which includes a second home and traveling to see his seven grandchildren. As a buy-and-hold investor, he says he doesn't worry about stock price swings. "What I care about is the ability of companies to pay their dividend," he says.

Stocks yielding close to 3% or more may look attractive compared with the 2.6% yield of ten-year Treasury bonds, but investors should remember that dividend stocks are not a substitute for fixed income. Although dividend payers tend to be less volatile than the broader stock market, they've been considerably more volatile than bonds. Retirement portfolios should remain broadly diversified among cash, bond and dividend stock holdings.

The challenge today is guarding those dividend holdings against the market's blows. While a scattershot approach to dividends may have worked in years past, investors should now take a more targeted approach to collecting those payouts. Here's how to refine your dividend strategy to focus on reliable and growing payouts in the years ahead.

Look for dividend growth, not current yield. Income-focused fund managers who have a lot of leeway to move money among bonds, stocks, convertibles and other asset classes have lately made some big shifts toward dividend stocks. But those shifts have largely focused on finding future dividend growth, not the highest current yield.

In the Franklin Income Fund, for example, just 36% of assets were in bonds at the end of June, down from 51% a year earlier, says manager Ed Perks. Instead of beefing up allocations to some of the market's highest yielding sectors such as utilities and real estate investment trusts, Perks says, he moved money into sectors offering lower yields but stronger dividend growth potential, such as technology, energy and materials.

Likewise, the Delaware Dividend Income Fund, which can invest in bonds as well as stocks, has shifted more money toward stocks in the past year, says manager Babak Zenouzi. At the same time, Zenouzi says, he deliberately lowered the yield in the fund by selling high-yield "junk" bonds and higher yielding REITs.

Many fund managers say they've retreated from higher yielding stock sectors largely because they've become too pricey as investors have gorged on the highest payouts they can find. "A lot of this yield-chasing is chasing very expensive and unsafe yield," Zenouzi says.

Older investors have additional reasons to focus on dividend growth rather than current yield. Steadily growing dividends can help maintain your purchasing power in retirement. And in some cases, a high dividend yield may indicate that the market has knocked down the stock's price in anticipation of a potential dividend cut or other troubles. (Dividend yield is the annual dividend per share divided by the stock price.)

Early last year, for example, investors punished the shares of Portugal Telecom (symbol PT) despite the stock's double-digit dividend yield. Shareholders thought the dividend wasn't sustainable, so the stock "didn't get any credit for having this high yield," says John Buckingham, chief investment officer at Al Frank Asset Management, in Aliso Viejo, Cal. Indeed, the company in mid 2012 cut the dividend in half.

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