Think carefully before swapping your bonds for dividend-paying stocks.
Just like a Hindu sage chanting “Om” before a prayer, investors should intone “Stay the Course,” one of the central tenets of successful, long-term investing, before making any changes to their portfolio. This is especially poignant advice during moments when market timing holds a particularly alluring appeal, such as when interest rates are at record lows and investors are scrambling to find any available yield in a seemingly stingy market.
Sticking with bonds is easy when declining interest rates make them abnormally profitable investments at a time when stocks get whipsawed by continual boom-and-bust cycles. Now that interest rates have hit rock bottom, however, many investors have begun to second-guess their commitment to the fixed-income portion of their portfolio.
Don’t Be Driven By Fear
Of course, given this unusual environment in which many investors are still scared of their own shadows and are scrambling over each other to throw money into risk-free investments, such wavering is understandable. With 30-year Treasury bonds yielding just a bit over 3%, inflation could eat up most, if not all, of your returns, even if interest rates don’t rise significantly over the next decade.
This situation is especially harrowing for recent and soon-to-be retirees, who were counting on higher yields to help them as they begin to draw down their portfolios. Given this fact, many of our clients have been asking us about the appropriateness of replacing bonds with higher-yielding assets like dividend-paying stocks.
At first glance, such a strategy looks mighty tempting. There are many Dow stalwarts like McDonald’s, Pfizer, Verizon and Johnson & Johnson that are offering yields north of 3%, and the SPDR S&P Dividend ETF, which holds only the most stable and consistent of dividend payers, is currently yielding 2.7%, higher than the current rate on a 10-year Treasury note. You can do even better if you venture into specific sectors like utilities and REITs, which have traditionally offered higher yields with relatively low volatility.
Don’t Expect Something for Nothing
Unfortunately, as even a third-rate economist knows, there is no such thing as a free lunch. Risk and return always go together, so you can’t chase yield by purchasing dividend-paying stocks or low-quality bonds without accepting an increased probability of significant losses. This is a very important point that bears repeating: When it comes to financial markets, you can’t get something for nothing. This fact is often lost among those who wish to dump bonds in favor of stocks paying nice, juicy dividends.
In addition, it is important to remind yourself of the fundamental role that bonds play in an investment portfolio. In particular, bonds are not designed to make you filthy rich; instead, they should be used to mitigate the risk you do take in the equity portion of your portfolio. When you replace bonds with stocks, dividend-paying or otherwise, you are not increasing your risk-free rate of return; you are explicitly accepting more volatility in the hopes of increasing your returns.
Don’t Be Fooled By Illusions
It is no coincidence that the excitement surrounding dividend-paying stocks comes at a time when the stock market itself is doing quite well. Everything seems risk free in a rising market, but this can be a very dangerous and expensive illusion. In the stock market, today’s leaders become tomorrow’s laggards. Indeed, the mere hint that the Federal Reserve would taper its bond-buying program drove down the prices of some dividend-focused ETFs and mutual funds by as much as 10% in just a few weeks time.
You should not allow short-term market idiosyncrasies to derail your carefully considered asset allocation strategy. The whole point of having such a strategy in the first place is to develop an appropriate plan for your given level of risk tolerance so that you can follow it through the best and worst of times. Don’t become so focused on dividend yield as to forget about the risks associated with increased price fluctuations. A 4% dividend on a mutual fund or ETF sounds great in a low interest-rate environment, but it won’t do you much good if its price falls by 20%.
