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If you depend on your investment portfolio to generate income to live on, the last several years have given you the challenge of a lifetime. And now, as if you need another obstacle to overcome, one influential economist believes that one of the only viable income-producing investments left could lead you to take too much risk in your portfolio.
With interest rates still near record lows, most investors simply can't afford to live on the paltry interest payments that most fixed-income investments pay out right now. Like it or not, they've largely moved on to buy dividend-paying stocks, which in many cases pay for greater yields. The big question, though, is this: Will replacing bonds with stocks eventually bring you even bigger losses? Later in the article, we'll get one answer from Vanguard Chief Economist Joe Davis. But first, let's look at the dilemma income-hungry investors face right now.
The big trade-off
It's easy to understand why investors are dissatisfied with traditional income-producing investments. After all, before the financial crisis, it was routine to find interest rates of 3%, 4%, or even 5% on risk-free investments. Even the occasional bank CD or savings account would give you attractive rates, along with the safety of FDIC insurance.
Nowadays, all that has changed. Most short-term CDs and savings accounts pay less than 1% right now, and even if you're willing to lock up your money for longer periods of time, you still won't get all that much of an income boost. And although credit unions and local banks sometimes offer better rates than you'll find at the big banks, even they won't pay enough to meet all your income needs.
By contrast, dividend stocks have exploded in popularity, thanks in part to some amazing yields. Mortgage REITs like Annaly Capital (NYSE: NLY ) and American Capital Agency (Nasdaq: AGNC ) have sustained double-digit percentage yields for years now, for exactly the reason that savers have suffered: low short-term rates that let mortgage REITs borrow cheaply and take advantage of interest rate spreads. Another specialized form of dividend-paying investment, the master limited partnership, has also blossomed, with fertilizer company Terra Nitrogen (NYSE: TNH ) and oil and gas producer Linn Energy (Nasdaq: LINE ) also giving shareholders hefty returns through dividend payouts.
Far from risk-free
What many investors forget about dividend stocks, however, is that they're stocks. As such, they're a lot riskier than bonds.
You don't have to look back very far to see good reminders of that fact:
- During the financial crisis, many seemingly healthy dividend-paying stocks ended up axing their payouts, hitting investors two ways. General Electric (NYSE: GE ) and Dow Chemical (NYSE: DOW ) , for instance, shocked many investors with dramatic reductions in their dividends -- reductions that they've only recently started to reverse.
- With mortgage REITs, interest rates have given them a perfect environment. But turn back to 2005, when rates were on the rise, to see what can happen when times change. Annaly saw its share price cut nearly in half, and its dividend payout dropped by 80% between the fourth quarter of 2004 and the fourth quarter of 2005.
- MLPs tend to trade in line with their respective sectors -- but often with more volatility. Linn, for instance, dropped 32% in 2008 even after adding back dividends that amounted to more than 16% of its final share price. Enterprise Products Partners (NYSE: EPD ) saw similar losses.
None of this means that mortgage REITs, MLPs, or other dividend-paying stocks are automatically terrible investments. But you shouldn't just dump your money into dividend payers and expect them to behave like bonds. When times are good, you'll earn a lot more from stocks than with bonds -- but if today's concerns turn into a full-blown new bear market, then you'll wish you'd taken your 1%.
Don't get fooled again
Sure, it's easy to focus on the reward half of the risk-reward relationship when things are going well -- but the good times won't last forever. As Vanguard's Davis puts it:
I just hope that we all appreciate that dividend-paying stocks are not substitutes for Treasury bonds. That's not to say that dividend stocks will not outperform a broad bond portfolio over the next several years. Rather, it's simply to say that such an income-focused strategy is not a no-brainer, nor is it risk-free.
That said, if you're going to invest in dividend stocks, you at least owe it to yourself to find the best ones out there. The Motley Fool has already done the legwork in producing its latest special report, with 11 strong dividend stocks with rock-solid businesses behind them. Click here to start reading about these stocks before everyone else finds out about them.
Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter here.