Stock dividends have been a hot topic for quite some time.  There are many reasons for this.  Over the next several days, I would like to address a few things on my mind as they relate to stock dividends.   

Today, I’ll focus on a dangerous investing myth having to with stock dividend investing.

The 10-year Treasury rate, even though it has risen over the past 4 weeks, now stands at an approximate 1.8%.  That’s right, for a 10-year investment in U.S. government bonds, you can earn a whopping 1.8% a year!  It’s no wonder that I’m frequently asked by clients (whose risk profile dictates a substantial fixed income investment) if investments can be switched from fixed income to high paying dividend stocks.

The impetus for these questions stems partly from the reverse-sticker-shock yields themselves (1.8% doesn’t get you much!).  But there’s another reason these questions come up.  This investment myth is perpetuated by those in the financial media.  I can provide a countless number of examples where financial market pundits have advocated switching from low yielding fixed income to higher paying dividend stocks.

Here’s just one:  In late December 2010, Suze Orman had 5 money tips for 2011.  Her very first recommendation was, “If you are investing, and you should be investing, you need to understand that in 2011 most likely bonds are over. You’re better off in good, quality stocks that pay high dividend yields — 4%, 5%, 6%.”

Now, it’s not that I have anything against Suze Orman.  I actually think that she’s very effective at translating consumer finance topics to those considered less than literate in matters of finance.  I also don’t mean to point out that she was so terribly wrong with her call–even though she was as bond prices rallied during 2011.  However, I do have a problem with how absolutely irresponsible this advice can be for the very uninitiated—which is her target audience.

The fact is that risk equivalence for an investment in stocks is completely and totally different than an investment in bonds.  Stocks, no matter if they have high dividends or not, are just plain more risky than bonds.  Jeffrey Gundlach, the famed bond investor, provides a bottom-line example why by saying, “If the yield on the ten-year bond doubles overnight from 3 to 6%, you’ve lost about 20% of your principle – but if Microsoft’s yield doubles from 3 to 6% overnight, you’ve lost 50% of your principle.”  In other words, the two types of investments are apples and oranges.

Could it be appropriate for an investor to switch from more fixed income to high yielding stocks?  Absolutely.  Especially if the forecast is for higher future interest rates (as interest rates rise, bond prices go down) and better economic times ahead.  However, it’s absolutely mandatory that the investor’s risk profile will allow for the additional risk associated with increased stock exposure.

James Bianco accurately describes it like so, “Rather than viewing dividend stocks as a way to capture extra yield, in the past we have stressed that dividend stocks should simply be viewed as a slightly less risky form of stock investing. As such, we should expect dividend-paying stocks to outperform during bear markets and underperform during bull markets.”   As evidence he uses data from the bear market of October 2007 to March 2009 where an index of dividend paying stocks outperformed the S&P Equal Weight Index by 10%.  On an annualized basis, dividend stocks returned -36% versus -46% for the S&P Equal Weight Index.  In other words, the dividends provided safety compared to other non-dividend stocks, but for an investor living on a fixed income, a -36% return may not be recoverable given liquidity needs and a shorter time horizon.

The long and short of it is that investors need to recognize the inherent risks in attempting to chase yield by replacing one asset class (stocks) for another (bonds).

About these ads