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A reader left a lengthy question about how I determine how much of a client's portfolio goes into fixed income and what I thought about buying stocks with dividends and substitutes for low yielding bonds.

As the portfolio manager, it actually is not usually my job to determine asset allocation. Typically the percentages for equity and fixed income is part of the planning process, and at our firm, this is usually two different tasks. If a portfolio is going to have something of a normal asset allocation, then the fixed income portion is going to be between 25% and 50%, with most people being 30%, 35% or 40% fixed income... again if the portfolio is going to be normal. We have a few clients who, as a function of their volatility tolerances, have more than 50% in fixed income.

There is, of course, a vetting or a get to know you process for trying to determine the correct mix and usually the result is correct, but sometimes, we do make a change for a client.

Fixed income has a couple of different roles in the portfolios we manage; one is to generate income and the other is to, as the reader suggests, act as a buffer for stock market volatility. Another potential role for fixed income is seeking capital gains through riskier positioning/trading. We are generally focused on the first two, not that last one.

The more important question is the idea of buying dividend stocks as a substitute for low yielding bonds. This is something that has become popular to some degree based on what I read and what some advisors are saying on stock market television.

This is the sort of thing that is destined to end very badly. It feels like the people advising investors to do this are the same type of people who had clients in way too much tech and then way too many financial stocks.

This is not to predict a bubble in dividend stocks such that the niche leads the market on a 50 or 60% decline, but when the market has its next bear market, dividend stocks will go down a lot because they are stocks, not bonds.

I think most people would consider clients holding Johnson & Johnson (JNJ), a dividend stock. It is up a lot lately and the yield has gone just under 3%, which is higher than the yield on its debt. However, despite being a dividend stock in a defensive sector, it still went down 30% in the middle of the crisis. This was much better than the broad equity market.

For someone able to focus on the long term, down 30% in a down 56% world is a good result where the context is equity performance. In the context of expectations for a bond-like result, a 30% decline would be catastrophic for a lot of investors. I can't begin to envision how I would explain that to clients who were expecting dividend stocks to be a substitute for bonds because I had told them they would.

While it is unlikely that the next bear market for equities will bottom out with as much as a 56% decline, I would be happy if a stock like JNJ went down 15% in a down 30% world, which is still nothing like a bond-like buffer against equity market volatility.

There is, of course, a lot of interest rate risk now in most parts of the bond market. Because of the zero band concept, we know how little room there is for bond prices to keep going up, but of course, that does not mean that must go down, either. That we know bond prices can't really go higher, in a way makes things a little easier, we know where the riskier parts of the bond market are and we can choose to avoid them, but that is less clear with equities.

A big part of what I write about for bear market psychology is taking action early to prevent being in a position where an emotional response is likely. Buying dividend stocks as bond proxies strikes me as the exact opposite.

Money that should be in cash should be in cash. Money that should be in fixed income should be in fixed income. Buying dividend stocks as a substitute amounts to chasing yield, and that usually ends badly.

Source: Dividend Stocks Are Not Bond Proxies