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Dividend stocks deserve a second look at a fearful time

This investing approach recognizes that individuals differ from institutions

Tuesday, November 17, 2009 – 8:04 PM by Don Schreiber Jr.
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Don Schreiber Jr.: One problem with buy-and-hold is that when investors are faced with 40% to 50% declines, they sell to preserve their remaining capital.

Financial experts have traditionally reiterated ad nauseam that equities belong in a portfolio. The argument has been that, despite equities’ greater intrinsic risk versus bonds or cash, they reward investors with higher returns over long periods of time.

Conventional investment wisdom continues to recommend that financial advisers create buy-and-hold asset allocation portfolios, focused on growth stocks, to obtain high returns over the long run, while ignoring short-term volatility and risk to capital.

This approach seemed to work when the greatest secular bull market in history hid its flaws in the 1980s and 1990s. But after huge losses last year, many investors are revolting. The concept of buy-and-hold grew out of the belief that you can’t time the market. Investors have accepted market volatility because stocks have been the only financial assets that provide a return that has outpaced inflation.

However, this argument ignores a core problem: Investors don’t buy and hold. Stock markets will always give them more risk than they can tolerate. When faced with 40% to 50% declines, they sell to preserve their remaining capital. In theory, market returns will always bail you out, so investors shouldn’t worry about losses. The unfortunate truth is that if an investor loses enough capital, he or she may never recover.

Dissimilar Reactions
In the wake of the tsunami that has devastated the financial sector, advisers need to fully recognize the serious flaws in the conventional approaches. The money management community has combined several different theories to justify ignoring short-term risks to capital.

First, modern portfolio theory suggests that a diversified portfolio will sufficiently limit risk to capital. Yet, last year, we saw all asset classes fall hard, proving that diversification alone isn’t enough.

Second, conventional wisdom suggests that asset allocation policy determines 90% or more of returns. This was an outgrowth of the approach taken by pension funds.

But the hypothesis that successful institutional investment strategies can be applied to individual investors is fundamentally flawed. Pension fund managers react differently when their accounts lose value: It’s not their money. In addition, they tie investment success to relative performance. If they outperform their benchmark in a down market, by posting a 35% loss versus a market loss of 38%, they don’t lose their jobs.

The truth is that individual investors do not possess the same risk tolerance as institutional investors. Faced with the same declines, individuals will bail on their investment plan while a portfolio manager will endure for a longer period of time. When market cycles turn negative, individual investors compare their performance to what they could have obtained in a certificate of deposit.

Dividend Stocks to the Rescue
Another flaw in this traditional passive approach is that secular market trends last a lot longer than most people think. Our historical market research shows that positive and negative return cycles average 17 years in duration.

Most advisers know that stocks have provided investors with about a 10% rate of return over the past 100 years, but most don’t realize that 53% of the return has come from price appreciation and 47% from dividends. Dividends can provide a reliable source of cash flow that can be reinvested to promote compounding and dollar-cost averaging, or taken as income to support lifestyle.

Without dividends, market performance would be truly disappointing. The return from price appreciation over the past century has averaged only 5.26 percent. Not many investors would be excited about investing in stocks if they were to disregard the additional return from dividends.

One of the big selling points for dividend paying stocks is that they are often a safe harbor during uncertain times. Investors can count on the steady and reliable return from dividends. Dividend payers tend to be less volatile; and this is a major appeal, as not too many investors can tolerate huge market drops or extended periods of volatility.

Perfect example
The 2000-2002 bear market cycle provides a perfect example. During that time, the dividend-focused Dow Jones Industrial Average Index fell 26%, while the growth-stock oriented NASDAQ Composite Index fell 67%.

During bear-market cycles, it is dividends, not price appreciation, that provides investors with positive returns. Therefore, dividend-paying stocks, not growth stocks, should be the building blocks of the portfolio construction process.

Here are some other guidelines to consider in this changing market:

• A successful investment process must control risk to capital to allow investors to stay comfortably invested in both positive and negative market cycles.
• New approaches should be active and responsive to changing market conditions.
• Portfolios should focus on value to identify opportunities to buy low.
• Stocks should primarily be dividend payers to generate cash flow.

Don Schreiber Jr. is president and chief executive of Little Silver, N.J.-based WBI Investments, which manages $325 million using a high-yield dividend-paying strategy.

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