Picture Credit: Quinn Dombrowski || Today we’re going to play the “tiny game.” How about a T-bill? Oh, you won, you showed me the interest on your checking account…
This article arises out of two articles that I’ve read in Barron’s over the past 3 months. One was in early January, and it was the front page article on income investing. The other was the front page article for this past week, and it was on dividend paying common stocks as a means to finance your retirement.
With the first article on income investing, the main point I was going to make is that risky bonds and other investments that carry high yields usually embed some sort of equity risk. In a scenario where the credit cycle goes bearish, those risky investments will be as risky as common stocks for the duration of the bear market.
Remember that the time to buy risky assets is when most other people and you are scared to death in the midst of a bear market. Or, wait until the price cuts above the 50-day moving average. Don’t be a yield hog when market valuations are so extended.
But for the article in this week’s Barron’s, my point is a different one. Many people have gotten too comfortable with the concept of using dividend paying common stocks for income in retirement portfolios. The first thing you have to remember about dividend paying common stocks is that they are stocks. Over short horizons they carry considerable risk of loss of principal.
What does that imply for the investor that wants to pursue such a strategy? It means that he must have a long enough time horizon and a diversified portfolio that has some safe assets in it. This allows the investor to be able to ride out a temporary decline in the market, together with any dividend cuts that you might face in a bearish market environment. The safe assets can be tapped to provide emergency spending money, or used to buy cheap dividend paying stocks amid the carnage.
Now, you can mitigate some of these risks by buying high quality dividend paying common stocks. Note: you will have to give up some income to do this. Those stocks have adequate coverage for the dividend and adequate ability to reinvest in their business. They sport reasonable prices relative to their earnings potential.
You can also mitigate the risk even though it does not pay much yield at present by owning a ladder of bonds or bond funds with high credit quality. Remember that laddering is consistently the second best strategy with respect to interest rate risk. Being good at forecasting is the best strategy, but who can be so good?
If you do it this way, which is similar to the income strategy that I do for older folks, you will never get thrown out of the game via panic. In my investing, I never go below 60/40 stocks/bonds, and I never go above 80/20 stocks/bonds. Right now I’m at 65/35, and I’m thinking about going to 60/40.
Even though I think the market on the whole is overvalued, there are many niches in the market that are not. There are areas with stocks that have a reasonable price earnings multiple, accompanied by a reasonable dividend. That said you won’t be in the part of the market that has been popular for the last several years. Few people want to take the path that has underperformed in the recent past.
To summarize: if you have so much assets that the yields on your dividend portfolio will never provide less income than what you need, great, go ahead and invest solely in dividend paying common stocks. But if you want to avoid the panic in the bear markets and perhaps take a little bit less in return but still do well over the long haul, do what I do: run a portfolio that’s a balanced fund where the stocks pay dividends. With a portfolio like that you won’t win awards in a bull market but you will feel very comfortable in a bear market and not be scared or pressured to sell at a bad time.
David – while I can’t argue with any of your points about stocks and equity risk, the discussion is very incomplete.
You will, with 100% certainty, suffer a purchasing power loss if you buy bonds. The risks are doubled if you buy US treasuries… even if inflation does not increase. Real world investors face healthcare and college costs (climbing double digits for decades), not to mention food, energy and labor costs (try hiring a plumber or electrician). CPI is an irrelevant statistic. Investors need to hedge real world costs.
With socialism now controlling Washington DC, there is a risk the government will default on principal, not just interest. The US defaulted under FDR, and defaulted again at the end of LBJ / start of Nixon. Since it happened twice already, it’s stupid to claim it can’t happen.
Bonds are very very risky right now. Far more risky than stocks, even with stocks at crazy levels. Quite simply, if the economy (aka the tax base) has problems, the tax collectors will have problems too. See all the banana republics.
And an honest discussion of risk should mention that the UK defaulted, and needed an IMF bailout, when they went socialist.
None of the octogenarians in DC frivolously wasting credit will be alive when the current ten year note matures… Biden is a question mark for outliving the current two year note.
Right now, If we apply standard moody / S&P criteria, US treasuries are junk bonds.
Government bonds are only as safe as the tax base that supports them. If a diversified basket of dividend stocks goes bad, then so will the government’s tax base and government bonds.
I’ve heard the quacks in academia ramble on about efficient markets and risk free bonds — but those who can do and those who can’t teach under the protection of tenure.
For investors who don’t have tenure, and for those managing the endowments that support the tenured children’s pensions — stocks are less risky than certificates of confiscation
Stock prices can go up and down (so can bond prices!), but roughly half the time they will go up or stay flat.
The possibility of a gain in stocks is better than the certainty of loss in treasuries.
At $25 trillion debt, plus another hundred trillion in unfunded promises, the federal government will have to do another “reset” aka partial default — paying its debts in part but not in whole. Another commenter above pointed out the US government has done a partial default twice in the last hundred years, it’s perfectly reasonable to suggest they will do another partial default.
Aggregate taxes (federal, state, local) are already near the high end of G7 countries. Misinformed comments that compare US federal rates with foreign total rates only serves to highlight that commenters don’t research- they mindlessly parrot what media personalities tell them to think. Compare total taxes with total taxes, and the US is already near the top. We were the highest taxed before Trump tax cuts. You can dislike Trump personally and still admit he was right about taxes.
The US government does not have a revenue shortage, it has a spending problem.
Biden’s $1.9 trillion was 65% political pork, and the next spending spree proposal is at least 80% pork. It exemplifies the US SPENDING crisis. Don’t even get me started on perpetual wars that Washington DC insiders all profit from.
The US government has a spending problem, and at this point they can’t pay in full even if they wanted to. Another partial default is a question of when, not if.
A diversified portfolio of dividend stocks (not 100% high yield stocks) is a much lower risk than treasuries, which are guaranteed to lose money versus cost of living and highly likely to suffer partial default.
There is risk in both stocks and bonds, and I’m surprised David talked about the risk in richly priced stocks, while completely ignoring the risks in richly priced bonds from a deep debtor that can’t control spending. At 1.7% yield on ten year treasuries, bonds are extremely risky. Let’s have full disclosure of ALL risks please.
I am a little old fashioned — I believe that the value of securities should be based on the cash flow of the enterprise they fund.
There are many stocks with extremely rich valuations. But if you avoid them, and invest in business with sound cash flow that can fund their dividends, well, you should do OK. And OK is good enough.
I appreciate the work you have done but IMO addressing business fundamentals is better.
Bonds are a series of specific money promises – you pay for the bond at market value, and you receive periodic interest payments, and a return of principal at maturity. The bond risks are 1) credit default and 2) loss of money value over time. The 1970’s are the classic period of realized bond risks based on loss of money value. A long term bond held from 1970 until 1980 lost at least half its value, because of inflation.
A stock market downturn during a period of high realized inflation very clearly threatens balanced portfolios, with both stocks and bonds declining. While stocks can survive inflation in the long term, the short term insurance value of bonds is negated by inflation.
Questions: 1) what are good proxies for current inflation ? (the CPI consumer price index is an incomplete measure – commodities ? labor rates ? something else ?) 2) what are reasonable hedges for inflation ? (in the 1970s gold was an effective hedge if you replaced the bond portion of the portfolio with: 88% bonds / 12% gold).
A balanced portfolio works until bonds under inflation are no longer effective as insurance. The balanced portfolio needs another investment to offset bond risks under inflation. What is that investment (or choice of investments), and when does the balanced portfolio need that secondary inflation insurance.