By Melda Mergen, Managing Director, Head of Equities
Investors who let volatility affect their investment strategy may never achieve their income goals. In today's turbulent market, an equity income portfolio can offer more than just dividends.
The goal is income, but investors can get easily distracted when the stock market turns volatile. In today's slow-growth economy, investors view even minor market events as warning signs, triggering the emotional reactions that contribute to market volatility. During those ups and downs, you need a strategy that helps maintain a focus on income goals. When stock markets are volatile, equity income portfolios can offer investors dividends - and much more.
The principles outlined below can help keep income-oriented investors on track, even when volatile markets have them on edge.
1. Focus on high-quality income for downside protection
Stocks selected for their high-quality income tend to offer greater protection during periods of market turbulence, due to relative price stability and income that contributes to total return. As one indicator of price stability, dividend stocks in the S&P 500 Index have lower standard deviations (15.9%) than stocks that don't pay dividends (24.9%).1 Standard deviation is a measure of volatility, so this lower standard deviation from dividend stocks indicates less volatility.
Companies considered suitable for quality income equity portfolios typically have the following attributes that contribute to their relative price stability:
- Strong balance sheets with limited debt and ample free cash flow.
- Reliable business models.
- A track record of spending their money in shareholder-friendly ways.
- They likely have the will and capacity to prudently increase dividend payouts over time.
2. Diversify equity income across sectors
Diversification within a high-quality income equity portfolio can further limit the risk of price declines from sectors that are particularly stressed in volatile markets. Equity income strategies are not limited to the few sectors once associated with yield, such as utilities, telecom and energy.
The dividend yield of the S&P 500 Index, currently 2.13%, is nearly unchanged from its level of 20 years ago. But the composition of sectors within the index offering quality income has evolved. The following exhibit demonstrates that investors don't need to rely on the three top-yielding sectors (utilities, telecom and energy); the opportunity to find quality income has improved or remained steady outside of these sectors. Opportunities have improved in sectors such as information technology, consumer staples, materials and industrials.
Change in dividend yield across sectors2
3. Don't limit yourself to yield-chasing stocks
Stocks with solid, higher dividends and others offering lower yields but great potential for future income growth both have a place in portfolios. Periods of volatility are likely to impact these different types of income stocks with varying degrees of intensity. The strength and growth of a stock's dividend income, not just its current yield, remain the key investment factors. The act of merely chasing yield in any kind of market can work against the long-term goals of a quality equity income portfolio.
The greatest danger of not achieving income goals is the temptation for investors to exit the equity market entirely. Quality dividend stocks can help ease that tension by limiting the risk of short-term price declines, while providing a long-term answer for investors who need income now - and assets that can grow in the future.
1. Source: Ned Davis Research. Monthly data 01/31/72-12/31/15.
2. Source: FactSet. S&P 500 Index as of 04/30/96 and 04/29/16.
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