Dividend-paying Stocks: Beware One Monster Risk

Posted on August 3, 2012 at 12:49 PM PDT by

Dividend-paying stocks for income are certainly the flavor of the month for retiring Baby Boomers. There’s a lot to be said for owning a piece of a well-run business, as Warren Buffett would surely agree. But there’s also a significant, widely misunderstood risk in relying on dividend-paying stocks.

One of the curious effects of the credit crisis and of the Great Recession that followed has been the degree to which government — rather than, say, economic growth or management prowess — has led the market.

Dividend-paying stocks: Beware One Monster Risk

You need only look at the return on U.S. Treasuries to see the effect. The U.S. Federal Reserve has been stomping on the monetary gas pedal for years now. Interest rates are low, low, low. Yet the economy barely sputters along.

On the flip side, companies have been piling up cash. Some of that money is finding its way to shareholders via buybacks, and companies are reinvesting in their own operations. There’s even some M&A to show for it.

Most obviously, though, the combination of steady corporate earnings and a stagnant economy has led to a strong secondary effect: the yields on dividend-paying stocks have shot up.

From Bloomberg News:

With the dividend yield of the Standard & Poor’s 500-stock index exceeding the U.S. Treasury 10-year note, a phenomenon not seen for roughly six decades, some investors are swapping into equities as an income alternative to bonds. That’s because the average dividend yield on the S&P 500 is 2.5 percent, compared with the yield on 10-year U.S. Treasury bonds of 1.45 percent.

The result, according to Bloomberg sources, is a shift among some wealthy investors away from bonds and into stocks for the income they provide.

Long-term research on stocks shows that investors should hold a portion of their portfolios in so-called “risk” assets. Jeremy Siegel, the Wharton finance professor known for arguing the case for stocks, not long ago strongly recommended substituting dividend-paying stocks for bonds. He flatly considers bonds a bubble. We wouldn’t disagree.

When dividend-paying stocks turn ugly

Should you get out of government debt and buy instead a collection of U.S. blue chips? As alluring as that might sound given the current bond yield, there’s no need for such a rash approach.

The one great unknown in all of this remains the government. The Fed has been quite plain about its intentions so far. But no one really knows if the rate-setting committee, the FOMC, will ramp up its bond-buying strategy — known as “quantitative easing,” or QE — hold steady, or reverse course. You hear a lot of from both sides of the argument, from gold bugs and stock bugs and everyone between.

Still, even bond guru Bill Gross got it wrong, and he’s a full-time pro. There’s a lot to be said for recognizing one’s own, human limitations. Gross is paid handsomely to be extra cautious, and being wrong cost him.

By the time a new course is set, the market will have already moved in anticipation. Big institutions with huge leverage will rearrange their chips in a flash, leaving individual investors chasing the new reality. Whatever the strategy of the super-rich, the intelligent choice is not to fight the market but to tag along.

A smartly allocated portfolio is agnostic when it comes to the dividend-paying stocks vs. bonds argument. It holds rational percentages of each, carefully balancing the risk. And it allows you the wiggle room to take advantage of momentary insanity in the markets — without the sleepless nights.