Dividend-Paying Stocks May Be Riskier Than Many Think

Cahn suggests a rather radical approach: selling stocks that have appreciated in value, rather than buying bonds or dividend-paying stocks, to generate income. This strategy is “more tax sensitive,” and “you can time when you get the income,” says Cahn. “We prefer a program of investments that targets total return and then time the sales to maximize tax efficiency of a portfolio,” says Cahn. “That’s a much better strategy than chasing yield.”

Cahn does use bonds in the portfolios he manages but as a hedge against stock allocation for market downturns rather than as income-generating investments. He favors longer duration bonds — generally with longer maturities — “to offset stock market losses” rather than short-term bonds that many advisors favor now, at a time when rates are expected to rise.  Short-term fixed income securities are favored because they won’t lose as much value as rates rise and they can then be rolled over into securities paying higher interest.

But that approach failed last year relative to long-term bond portfolios. The Vanguard Extended Duration Treasury Index Fund and the PIMCO Extended Duration Fund, which favor long-term bonds, for example, returned more than 45% last year, according to Morningstar Inc. — well above the 11% in the S&P 500.

As for the stock portion of portfolios, Cahn uses what he calls “quantitatively enhanced indexing” plus individual stocks – focusing on high profitability and momentum with low volatility — all at a reasonable valuation. “Whether a company does or doesn’t pay a dividend is irrelevant,” he says.

— Check out Is Portfolio Diversification Overrated? on ThinkAdvisor.