Wednesday, August 8, 2012

For Me, Nothing's Changed ... Own Dividend Paying Stocks and Stay Away From Bonds ... Not Everybody Agrees

More than a year ago, we strongly recommended that long term oriented individual investors embrace the unusual and certainly unconventional approach of owning 100% stocks, zero bonds and hold little cash in their investment accounts for the next several years, if not decades.

{NOTE: Please see our post of July 1, 2011 titled "for the long run, own stocks; skip bonds and cash." We still feel the same way and look forward to "staying the course" for at least several more years.}

That said, others feel differently, and it's worthwhile to listen carefully to other points of view, especially those that may differ somewhat from our own.

In that regard, Dividend-paying stocks: Beware one monster risk has this to say:

"Dividend-paying stocks for income are certainly the flavor of the month for retiring baby boomers. There's a lot to be said for owning a piece of a well-run business, as Warren Buffett would surely agree .

But there is also a significant, widely-misunderstood risk in relying on dividend-paying stocks.

One of the curious effects of the credit crisis and of the “Great Recession” that followed has been the degree to which government — rather than, say, economic growth or management prowess — has led the market. . . .

The U.S. Federal Reserve has been stomping on the monetary gas pedal for years now. Interest rates are low, low, low. Yet the economy barely sputters along.

On the flip side, companies have been piling up cash. Some of that money is finding its way to shareholders via buybacks, and companies are reinvesting in their own operations. There's even some M&A to show for it.

Most obviously, though, the combination of steady corporate earnings and a stagnant economy has led to a strong secondary effect: The yields on dividend-paying stocks have shot up. From Bloomberg News :

“With the dividend yield of the Standard & Poor's 500-stock index exceeding the U.S. Treasury 10-year note, a phenomenon not seen for roughly six decades, some investors are swapping into equities as an income alternative to bonds. That is because the average dividend yield on the S&P 500 is 2.5%, compared with the yield on 10-year U.S. Treasury bonds of 1.45%.”

The result, according to Bloomberg sources, is a shift among some wealthy investors away from bonds and into stocks for the income they provide.

Long-term research on stocks shows that investors should hold a portion of their portfolios in so-called "risk" assets. Jeremy Siegel, the Wharton finance professor known for arguing the case for stocks, not long ago strongly recommended substituting dividend-paying stocks for bonds . He flatly considers bonds a bubble.We wouldn't disagree.

When dividend-paying stocks turn ugly

Should you get out of government debt and buy instead a collection of U.S. blue chips? As alluring as that might sound given the current bond yield, there is no need for such a rash approach.

The one great unknown in all of this remains the government. The Fed has been quite plain about its intentions so far. But no one really knows if the rate-setting committee, the FOMC, will ramp up its bond-buying strategy — known as "quantitative easing," or QE — hold steady, or reverse course. 

You hear a lot of from both sides of the argument, from gold bugs and stock bugs and everyone between.

Still, even bond guru Bill Gross got it wrong, and he's a full-time pro . There's a lot to be said for recognizing one's own, human limitations. Gross is paid handsomely to be extra cautious. And being wrong cost him.

By the time a new course is set, the market will have already moved in anticipation. Big institutions with huge leverage will rearrange their chips in a flash, leaving individual investors chasing the new reality. Whatever the strategy of the superrich, the intelligent choice isn't to fight the market but to tag along.

You have to be careful selecting a dividend-paying ETF because some have a high exposure to financial sector stocks, mid- and small-cap stocks, or an overexposure to utilities or REITs.

Stick with the Vanguard High Dividend Yield Index ETF for owning a basket of dividend-paying stocks. It has paid a nearly $1.40 last year, a little under 3%. The stocks in this are the megacap U.S. "battleships" and are well diversified.

A smartly-allocated portfolio is agnostic when it comes to the dividend-paying stocks vs. bonds argument. It holds rational percentages of each, carefully balancing the risk. And it allows you the wiggle room to take advantage of momentary insanity in the markets — without the sleepless nights."

My View

Owning strong companies with a long history of paying increasing cash dividends to its shareholders has been my basic approach for many years. I don't plan to change it now.

In fact, this is still a great time to use the "substitute blue chip dividend payers for bonds" approach to individual investing.

When it comes to investing, I'm also very much a DIY individual who avoids "paying" for free lunches, birthday cards, nice looking regular written summary reports and the accompanying high fees which come from the "experts." For me, it's a make and not buy approach to individual stock buying.

As always, there are no guarantees, but this buy stocks and stay away from bonds idea seems like the closest thing I've seen to a great investing idea during the past several decades.

Thanks. Bob.

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