Investors, especially retirees, often use their portfolios to generate income. With bond yields and interest rates on CDs and money markets at record lows, these investors are searching for alternatives to meet their income objectives. Spurred by the headlines in some of the popular consumer finance magazines many of them are heading down what could prove to be a perilous path, trading their bonds for dividend- paying stocks and the mutual funds that invest in them.
On the surface, the idea of replacing low-yielding bond investments with blue chip stocks that offer not only a higher yield but also the potential for capital appreciation if stock prices continue to climb seems like a sensible move. However, upon closer scrutiny, the logic of this strategy contains some serious flaws. While both investments are used to generate portfolio income, savvy investors recognize that stocks, including those of dividend-paying, blue-chip companies, are on opposite ends of the investment risk spectrum when compared to bonds.
Specifically, dividend-paying stocks are about four times more volatile and, therefore, carry four times the potential for loss than high-quality bonds. So, the strategy of substituting dividend-paying stocks for bonds to generate more income results in a more aggressive and less diversified portfolio.
High-quality bonds provide important diversification and stability to investor portfolios particularly during times of financial crisis when it is needed most. The starkest example of this was the 2008–2009 financial crisis. Between the stock market peak on Oct. 9, 2007, and its subsequent low on March 9, 2009, the portion of investor portfolios consisting of high dividend-paying stocks lost around 50 percent of their value while the portion consisting of intermediate-term U.S. Treasuries gained about 15 percent. Investors with equity heavy portfolios including those with dividend-paying stocks experienced steep declines and enormous emotional turmoil while those with balanced portfolios of stocks and bonds fared much better.
So, the key question you have to answer is: “Am I willing to, and can I afford to accept greater risk of a significant decline in my investments to earn a higher yield?” For most retirees who are drawing down rather than adding to their portfolios, the answer is likely to be no.
John Spoto is the founder of Sentry Financial Planning in Andover and Danvers. For more information, call 978-475-2533 or visit www.sentryfinancialplanning.com. This article is for general information purposes only and is not intended to provide specific advice on individual financial, tax, or legal matters. Please consult the appropriate professional concerning your specific situation before making any decisions.