Editor's Note: This is one in a series of commentaries by financial-services professionals.
In a quest for protection from increasingly volatile markets, investors have yanked a page out of legendary value investor Benjamin Graham's tome, The Intelligent Investor, and are persistently seeking investment strategies that provide them with a safety edge.
Over the last few decades, conventional investment wisdom has taught most investors to seek the highest return from growth stocks, create diversified, yet passive (buy and hold), portfolio allocations, and ignore short-term volatility in order to reap the benefits of rising stock prices over time. In theory, this strategy can work for them. However, reality is that investors must be willing to endure potentially significant declines in the portfolio value in order to achieve their goals.
Regretfully, this strategy has miserably failed, as it is hard for the average investor to ignore volatility and declining account values. Very often, they succumb to the itch to take action and embark in a quest to shield their portfolios from the adverse impact of the falling markets. By doing so, they abandon their original plan of "buy and hold" and oftentimes end up selling low -- not high -- ultimately, causing a significant erosion of their capital base. High returns offered by growth stocks from price appreciation during bull market trends have become elusive to investors in recent years.
The rules of investing are undergoing a dramatic change, as investors revolt against failed strategies and become more aware of the fact that dividend-paying stocks, not growth stocks, should become the foundation on which portfolios are built.
When the government lowered the tax on capital gains for the first time in 1981, a new tax-driven preference for owning growth stocks caused many investors to forget about dividends and the benefits that they provide. In a rush to pay lower taxes, safe and consistent quarterly dividend (a component of return) was abandoned in favor of pure price appreciation - the only component of growth stocks. Unfortunately for investors, prices fell fast and hard, as the remarkable bull market of the '80s and '90s became a distant memory.
Back in the Spotlight
The good news for advisors is that dividend-paying stocks are back in the spotlight. In 2003, the government passed new tax legislation removing the arbitrary tax preference for returns generated by capital gains and provided tax relief to returns from dividends. This prompted a significant number of investors to revert to increasing their allocations to dividend-paying strategies.
One of the big selling points for dividend paying stocks is that they often provide a safe harbor during uncertain times. Investors can count on the steady and reliable return from dividends. In addition, dividend payers tend to be less volatile; which provides a major appeal, as huge market drops or extended periods of volatility are hard to stomach for the average investor. During the 2000-2002 bear market, the dividend-focused Dow Jones Industrial Average Index fell 26%, while the growth stock oriented NASDAQ Composite Index fell 67%.
Recent research has debunked the notion that dividend stocks provide less return than growth stocks. Ned Davis Research Inc., one of Wall Street's prominent research firms, released a study that shows that dividend-paying stocks have outperformed non-dividend paying stocks dramatically. Although stock prices tend to fluctuate more wildly, dividend returns tend to be more consistent, providing returns more silently but surely over time. As a consequence, it's not a surprise that during bearish markets, dividend stocks outperform their non-dividend-paying counterparts.
Current market volatility is bringing back flashbacks of the 2000-2002 bear market -- when popular index averages slid 50-70% -- and investors are starting to look for the exits. To help investors, advisors should consider shoring up portfolios with high-yielding dividend-paying stocks. This is due to the fact that traditionally high-yielding dividend stocks are characterized by lower volatility and the ability to offer investors more return opportunities. Many market pundits are forecasting modest price appreciation of 5-6% from stocks over the next decade, so why not match appreciation with a 3-5% dividend yield to generate the 10% historical rate of return that most investors want?
Avoiding "Dollar-Lost Averaging"
The vast majority of U.S. investors are getting closer to retirement and consequently becoming increasingly more risk-averse. Their focus is shifting from accumulation to capital preservation, as every penny will be needed to generate income while in retirement.
To effectively address the specific income and inflation protection needs of retirees, financial advisors should create for these individuals balanced portfolios that employ a mix of bonds and high-yielding dividend paying stocks to lower overall risk. Although bonds don't generally keep pace with inflation, the higher income they generate coupled with high-yielding stocks has the effect to produce an attractive level of income and inflation protection. Companies that pay dividends tend to increase dividends over time and stock appreciation can be used to further increase income in an effort to fight inflation.
Another conventional piece of investment wisdom that, to date, has turned out to be a mere disaster for retired investors is the systematic use of withdrawals from growth stocks or growth portfolios to generate income. The ongoing theory recommends that income investors select growth strategies and then systematically sell appreciated shares at ever-higher prices to fund their income needs. The reality is quite different. Share prices fluctuate widely causing investors to sell more shares when prices are low, thereby accelerating capital liquidation. In addition, sustained market declines can lead to so much capital erosion that retirees can lose their ability to generate income entirely.
Market volatility turns systematic withdrawal plans into the evil twin of dollar-cost averaging, which I like to call "dollar-lost averaging." In its mildest form, dollar-lost averaging increases the risk of outliving capital. As the flaws of this widely promoted strategy become more commonly known, advisors and financial services firms are finding that the compliance risks associated with this strategy are becoming a significant problem.
Active risk management (using stop-losses for stocks and active-duration management for bonds) can further immunize portfolios from market downturns and keep shaky investors comfortably invested. Today's investors are ready to embrace dividend-based investment programs that will keep them comfortably invested while achieving the returns they need to accomplish their growth and income goals.
Don Schreiber, Jr., CFP, is president and CEO of WBI Investments Inc., and has been using a balanced portfolio strategy to solve the risk and income concerns of advisor's retired investors for more than 15 years. He manages more than $300 million for advisors and is the co-author of All about Dividend Investing. For more information, see www.wbiinvestments.com.