Don't trust dividend stocks in a crazy market

Forgoing bonds for high-yield stocks amid the current volatility isn't as safe as you might think.

By TheStreet Staff Nov 18, 2011 12:18PM

main street logoBy Jeff Brown, MainStreet

 

With interest-bearing accounts paying practically nothing and bonds paying little more, many income-oriented investors are turning to dividend-paying stocks. But a fresh look at the numbers shows investors tread this path at their peril.

 

"More than $18 billion has poured into the Lipper Equity Income category . . . through September 2011, the largest amount of cash flow of any Lipper equity fund category year to date," the Vanguard Group reported earlier this week. "This seems to suggest investors may be looking beyond bonds in search of income."

 

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The Lipper Equity Income category includes mutual funds and stocks that, as the name suggests, try to maximize strong, steady income, primarily from dividend-paying stocks.

While there are many good investments in this category, Vanguard chief economist Joe Davis warns that high risks make dividends an overly risky substitute for investments that pay interest. In the term "dividend-paying stocks," the key word is "stocks."

 

You can see the issue clearly by looking at some standard measures. From Dec. 31, 1997, through Oct. 31, 2011, the average annual return of U.S. stocks was 4.2%, versus 5.7% for the dividend-paying stocks in the group, and 6.1% for bonds. That's right, bonds did better. Yields, or annual income from dividends or interest earnings, were 2.2% for all stocks, 3.7% for dividend stocks and 2.3% for bonds. Return adds interest or dividend earnings to the investment's price changes, up or down.

 

It’s important to note that stocks had an unusually bad run during that period, thanks to the dot-com collapse and financial crisis, while bonds enjoyed rising prices as falling interest rates made older, more generous bonds more attractive. Today, there’s no guarantee that bonds will continue to do so well, as rates are now very low and more likely to rise than fall, causing bond prices to drop in coming years.

 

A second performance gauge is standard deviation, a measure of how much the daily price of an investment tends to vary from its average price over a year. A bigger number means the price has wider swings up and down, which is risky for any investor who might sell during a downturn.

 

Over the period studied, the standard deviation for all U.S. stocks was 17.3%, compared with 15.3% for dividend stocks and 3.6% for bonds. In other words, dividend stocks behave like other stocks, presenting much more risk than bonds.

 

While Davis does not discuss interest-bearing accounts like bank savings, his point is relevant to those as well. Annual returns on a one-year certificate of deposit are terrible -- just 0.335%, according to the BankingMyWay.com survey. On the other hand, CDs and other federally insured bank savings have a standard deviation of zero, meaning they are risk-free.

 

So if you put $100 into a one-year CD, you’d be certain to get $100 back in 12 months. Put $100 into dividend-paying stocks, and you would get only $84.70 a year later if those stocks suffered an average downturn. That loss would more than wipe out the $3.70 you’d earn in dividends.

 

The stocks could instead go up, and history suggests that in the long run those stocks would be more profitable in the average year than interest-bearing accounts, but there could be a lot of sleepless nights along the way. Also, any dividends taken as cash and spent would reduce those stocks’ long-term returns, as those return figures assume all dividends are not spent but reinvested in the same basket of stocks.

 

Bottom line: Any money switched into dividend-oriented stocks or mutual funds should come from other stocks, not from the fixed-income portion of one’s portfolio -- unless you really intend to take more risk.

 

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7Comments
Nov 18, 2011 1:22PM
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Yes, there is more risk, SOMETIMES. The smart thing to do is take on that risk when the market has tanked, then it is really no risk at all. Get most of your money back into bonds when the market looks frothy. Unfortunatly, the average Joe does it the opposite way and looses his behind over and over.
Nov 18, 2011 2:39PM
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Smile Put $100 in a CD and get $0.96 back in 12 months after inflation plus 1 cent interest. Put $100 in a growth stock and get $80 back in a year after growth goes to zero or wait 5 years to maybe get $100 back. Put $100 in a dividend stock, get $4 during the next twelve months, and don't sell until it goes back to $100 or more.
Nov 18, 2011 11:31PM
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Yes, bonds may have beat stocks by a small margin since 1997, but during a large part of that time period cash/bonds actually earned some interest.  Currently and in the near future, you will receive little or nothing for cash.  Add to that the fact that bond values have little place to go but down (if/when rates go up) and I'm not so sure that bonds are a worthy purchase at present.

I think that both bonds and stocks are risky right now.  However, my focus for the last couple years has been on dividend growth stocks.... primarily major blue chips and utilities.  Our portfolio still has a large allocation to cash since I can't find many dividend stocks that are currently a good buy.  When the market goes down I'll be looking to buy more dividend producers. 

Nov 19, 2011 10:46AM
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havasu46: "Put $100 in a CD and get $0.96 back in 12 months after inflation plus 1 cent interest. Put $100 in a growth stock and get $80 back in a year after growth goes to zero or wait 5 years to maybe get $100 back. Put $100 in a dividend stock, get $4 during the next twelve months, and don't sell until it goes back to $100 or more"

 

....Good points, maybe add that if you are retired, or very close to it, there may be no need to consider selling the dividend stock, and hence no need to worry about share price.  If it yields a consistent, predictable stream of income to add to other sources (pensions, SS, etc.), that could be reason enough to hold it, so be happy with that.  Bank returns (CDs, MMKT) aren't a joke, they're insulting today. Growth stocks may eventually rebound, but I can't see it in even the intermediate future let alone the near term, so those are better suited to the much younger investors.     

Nov 20, 2011 11:41AM
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If what I hear day-in, day-out by the talking heads of the financial markets, is correct; i.e. "staying in stocks over the long haul will yield you your best return," then this "philosophy" should only allow you to prosper exponentially by primarily investing in quality, dividend paying, stocks (both common and preferred).  I did this in early 2009, when the market, across the board, tanked. . . . . . . .   I wish I had been this smart (or lucky) 30 years ago. 
Nov 21, 2011 7:01AM
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An average high yield bond mutual fund produces about a 7% return.  for a $250,000 investment thats about $17,500 annual return in income.  Not too shabby considering how low risk a high yield bond is in price fluctuation compared to stocks.  Not to mention, if you are income investing, price is irrelevant just as long as the dividend or yield does not drop.  Cheers.
Nov 19, 2011 11:24PM
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Dividend stocks are no better than the rest of Wall Street if you have no accountability in their records.
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