In the world of investing, it's a common trope that we need to be diversified. Hedge your bets, we're told: Own stocks in an array of companies and industries, and buy bonds for those years when the whole stock market tanks. But over the long term, investors pay a price for the security of bonds in the form of lower returns on investment. And that has led Motley Fool Answers listener Joseph to the idea that perhaps he can get a similar steady-income result from putting a share of his portfolio into high-quality dividend stocks.
In this segment from the July mailbag show, hosts Alison Southwick and Robert Brokamp -- and special guest Ross Anderson, a certified financial planner at Motley Fool Wealth Management -- discuss the pros and cons of that approach, weigh the fundamentals of the argument in favor of bonds, and consider some worst-case scenarios.
To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.
This video was recorded on July 30, 2019.
Alison Southwick: OK. The first question comes from Joseph. "I doubt the common wisdom of holding bonds. The logic seems to be that 1. bonds provide steady income, and 2. their value moves as a counterweight to the stock market. The net result is like a balancing seesaw of sorts, where your portfolio would be less volatile than not having bonds. However, I think Dividend Aristocrats or Foolish dividend-focused companies can better serve an income stream in retirement and replace that portion previously dedicated to bonds because 1. they are more likely to increase your income stream, and 2. increase your portfolio value over time. What do you think?"
Robert Brokamp: Well, Joseph, by mentioning volatility you really hit on the primary reason to own bonds, especially for retirees. But I would say there's another word that's a close cousin and that is "predictability." If you buy a five-year bond that pays 3% you know exactly how much you're going to get each and every year and how much it will be worth in five years.
[With] bond funds there's a little less predictability, but they're still really stable. Consider that since 1926 the worst year for the bond market was in 1994. That drop was a whopping 5%. So that's what people appreciate about them.
Compare that, of course, to the stock market, where it can drop 30% in any given year. You don't know when it's going to happen. It doesn't happen that often, but we've seen greater declines of 50% or more twice this century. That said, if you are willing to stick it out and you can stand that volatility, there's a lot of reasons to consider dividend-paying stocks -- especially higher-quality ones -- as an alternative to bonds.
While the stock market's prices will go up and down, the dividends are pretty consistent. When you look at the dividends paid by the S&P 500 since the S&P 500 began in 1958, there have only been two years when you've seen significant declines, and that was one year -- 1959 -- a decline of 12% in the dividends and then in 2009 when they declined more than 20%. And in between those, there was only six years where they declined just a little.
So as long as you can ignore the price volatility, relying on the dividends is an attractive way to create income because not only are they reliable, they tend to grow faster than the rate of inflation by about 1% over the long term. Plus, as we'll talk about a little later, qualified dividends have a favorable tax rate.
The only part of me in here is the "awfulizer."
Southwick: Here we go!
Ross Anderson: Here we go! Awfulize it.
Brokamp: Awfulize it. We're always basing this on history and there are times when the future looks different; sometimes in good ways and sometimes in bad ways. So I was thinking if we were having this discussion in 2007 and I would have talked about the historical drops in the dividends paid by the S&P 500, I would say, "The worst was 12%. They've never done worse than that," and then 2009 comes along and it's more than 20%.
So it is possible that the future will look worse. It is possible that we'll go through another stock market decline that looks more like maybe the Great Depression than what we saw so far this century. I don't think it's likely, but I think for that reason, most people should at least have a few years of the money they need -- if they're retiring in the next three to five years -- out of the stock market. But with the rest of it, if they want to go all stocks, that's fine.
And by the way, he mentioned the Dividend Aristocrats. Just so everyone knows, those are companies in the S&P 500 that have increased their dividends for 25 consecutive years, or at least paid them for 25 consecutive years. I think it's increased, though. Maintained them or increased them; so, those are high-quality companies. And you can buy those companies in ETF form if you really want a diversified, easy-to-purchase way of getting high-quality dividend payers.
Anderson: The only thing I would add, that I think is interesting here, is that if you're going to live off the dividends, the likelihood is that you're underspending what you could be and that your portfolio is going to continue to grow, and that's a great thing. I'm looking at the Vanguard High Dividend Yield ETF because it's a ticker I know off the top of my head. It's yielding about 3.3%.
So if you can live off 3% of your portfolio annually, that's a very safe way to do it and you're right. You're likely to see the portfolio continue to increase and that should be a fairly stable payout. But it's going to mean that your portfolio keeps growing and I'm not sure that most of our goals, if we're retirement-focused investors, is to have a portfolio that keeps ballooning as we charge into our 90s. I would rather live on a safe but comfortable portion of that portfolio on an annual basis.
That's the other question there. Is that enough money for you or could you be living a better lifestyle if you chose to treat the portfolio a little bit differently?