Being a dividend investor is a popular retirement investment strategy. In a relatively low yielding bond environment, income generated from dividend paying stocks seems to give investors the best of both worlds; consistent income from dividend cash flow and a chance for capital appreciation. For many people, this has been a home-run strategy.
Today, I’m here to talk about the dark-side of dividend investing, so that those of your who employ these strategies might better understand the risk inherent in your portfolios.
Dark-side 1: Stocks aren’t bonds
Seems obvious but think of the utility of a dividend only stock portfolio. Collect the dividends off of the stock portfolio as your retirement income. But what happens if you need more than the dividend cash flow? When the market goes down, dividend paying stocks are going down with it, so one is still playing a guessing game with market cycles and cash flow needs.
Dark-side 2: Style and Sector
Dividend and Income stocks tend to be Value Style Stocks. By investing solely in these style of stocks, you cut down exposure to the core and growth stocks. One also tends to overweight in certain sectors; one of these sectors is utilities which is not exactly where many managers would overweight in a rising interest rate environment.
Dark-side 3: Mutual Fund Single-Stock Concentration
For those who don’t wish to buy individual stocks or do not have the funds to properly diversify, an investor may consider a high yield stock ETF or mutual fund. If you look carefully at these funds, you will notice that their top holdings are extremely concentrated relative to let’s say, a broad based index fund. This is to give the higher dividend paying funds higher concentrations to boost the yield of the portfolio. It’s ironic that an ETF or mutual funds designed to give you stock diversification may be falling short of that mandate.
How do I mitigate the above risks?
I’d advocate for total return investing. In my opinion, this more diversified approach that adds growth style stocks and income producing bonds to the retirement portfolio is one for retirees to consider strongly. Core bonds have historically ebbed when stocks have flowed, and vice-versa. By constantly re-balancing between these asset classes and their sub-classes, one has a better chance to smooth out the peaks and valleys of the market that one will likely encounter throughout retirement.