Financial advisors and investors traditionally favor dividend-paying stocks as a key allocation in any comprehensive retirement portfolio, and Warren Buffett has famously earned billions owning such stocks. But Jim Cahn, chief investment officer of Wealth Enhancement Advisory Services in Minneapolis, says dividend-paying stocks are not nearly as safe or as remunerative as many think.
For one, says Cahn, dividend-paying stocks are more interest-rate sensitive than popularly thought and they will perform poorly as rates rise. He explains that investors owning these stocks as a substitute for bonds currently paying extremely low yields will likely lose value when rates rise, just like the bonds.
Also, says Cahn, “Some of the highest dividend-paying stocks tend to be some of the riskiest.” These include mortgage-backed real estate investment trusts, which are subject to even bigger losses as rates rise because they are often leveraged, says Cahn. They also include MLPs — master limited partnerships — which are subject to the volatility in the energy sector.
Dividend-paying stocks also tend to underperform, says Cahn. Since 2001, the Russell U.S. Large Cap High Dividend Index is up 99% on a total return basis while the Russell 1000 is up 130.8%, he says. Also, the Modigliani-Miller Theorem developed by Nobel prize-winning economists Franco Modigliani and Merton Miller “determined that payments of dividends has no impact on the value of a firm,” says Cahn.
Given this analysis, how should advisors and investors generate income?
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.”