Since the 2008/09 recession and market meltdown, higher-yielding dividend stocks have performed extremely well. In hindsight, this is not surprising given rampant risk aversion and the extraordinarily depressed interest rate environment. What remains perplexing is how tepid the global recovery has been, and exactly when interest rate normalization will begin.
Nonetheless, there is now a growing chorus forecasting impending rising bond yields and accelerating U.S. economic growth. Significantly higher bond yields would present a formidable challenge to dividend yields, and accelerating growth could easily ignite a fire under investor expectations. Accordingly, a logical conclusion might be that after an extended run, dividend yield stocks are about to significantly underperform, and it's now time to move on to higher-risk equity strategies.
I don't disagree with forecasts of impending higher bond yields or the prospect of accelerating growth and the consequential prospect of much higher stock prices. I do, however, believe there are other considerations one should reflect on before abandoning a dividend portfolio either in whole or in part.
To begin, you should ask yourself why you invested in dividend stocks in the first instance. If you bought them solely for their superior short-term capital performance during a risk-averse period, then perhaps it is time to move on. If, however, you have developed a portfolio of proven dividend growth stocks with the goal of superior long-term total returns (price and dividend income), I suggest you pause before doing anything dramatic.
In the context of long-term total returns, portfolio strategies emphasizing dividend yield have done exceptionally well. This was detailed in an investment research report published by RBC Dominion Securities (RBC Investment Strategy Weekly -- "Buy Dividends … Need We Say More," RBC Dominion Securities, Inc., Jan. 21, 2009). This research was based on the extensive data base compiled by Professor Kenneth R. French.
OK, you say, perhaps that is the case in long-term performance, but what about the short term? Isn't the long term made up of a series of short terms? Yes, it most certainly is, but the blunt reality is that no single investment style or strategy will outperform during all phases of an investment cycle. In risk-averse markets, dividend stocks that have low betas (price sensitivity relative to an overall market's index) do extremely well. Conversely, growth stocks (high beta) with lower or no yields outperform when expectations are high and risk is on. What's right for you depends on your core investment objectives, time horizon and risk tolerance.
These considerations are interrelated, and each should be carefully assessed before initiating any significant investment. In this regard, a financial planner or investment counsel may be of assistance. Your core investment objective simply relates to the purpose of the investment. For example, is it a college fund, a house purchase or a long-term retirement savings fund, etc.? Having identified the objective, the next -- perhaps most critical -- step is attaching the relevant time horizon. The more distant the horizon and the less the need for interim liquidity, the greater the latitude for investment risk. To the extent possible, liquidity needs should be planned for. For example, one does not want to be forced into selling a portion of his equity portfolio into a market downturn. Safety cushions and emergency funds should be put into highly-liquid, low-volatility investments -- e.g., bank savings, money market funds or very short-duration bonds.
As discussed below, price volatility for long-term investments is only relevant if you are actually in the market selling. Finally, risk tolerance refers to your personal attitude toward risk-taking. Even after carefully assessing your core objectives and identifying the associated time horizons, you may choose to tune up or down your risk exposure because of your personal risk biases. The key here is that you are now making an informed, conscious decision, and recognize the potential consequences of your risk exposure decision.
For true long-term investors who do not have liquidity needs (for this portion of their overall portfolio), Warren Buffett perhaps best articulated the appropriate attitude. The billionaire compared the daily fluctuations in stock values to an erratic neighbor standing near his farm property, yelling out offers for the land:
"If a moody fellow with a farm bordering my property yelled out a price every day to me at which he would either buy my farm or sell me his -- and those prices varied widely over short periods of time depending on his mental state -- how in the world could I be other than benefited," Buffett wrote. "If his daily shout-out was ridiculously low, and I had some spare cash, I would buy his farm. If the number he yelled was absurdly high, I could either sell to him or just go on farming."
That's not how equity holders often react, Buffett said.
"Owners of stocks, however, too often let the capricious and irrational behavior of their fellow owners cause them to behave irrationally," he wrote. "Because there is so much chatter about markets, the economy, interest rates, price behavior of stocks, etc., some investors believe it is important to listen to pundits -- and, worse yet, important to consider acting upon their comments."
To take Buffett's analogy one step further, assume for a moment that his moody neighbor also shouts prices to the farmer on the other side of his yard. My guess is that Buffett would be even less interested in those shout-outs. He fully understands the value and productivity of his farm, and is confident that it will continue to grow into the future. As a consequence, he is not at all fussed about what the going price of a farm two doors over may or may not be.
Similarly, are you comfortable with your current dividend portfolio? Comfortable in the sense that you have realistic expectations that its dividend income will continue to grow consistently into the future. If you are, and it proves to be the case, history suggests that competitive capital appreciation will take care of itself. Accordingly, shifting assets to simply catch an ebullient market phase may not be worth the risks relative to your dividend portfolio.
I am not suggesting that shifting to a more aggressive equity strategy necessarily makes you a moody fellow, only that you seriously revisit your core objectives, time horizon and risk tolerance before making strategic risk adjustments to your portfolio.