(MoneyWatch) Many investors are seduced by the allure of dividend-paying stocks, tempted by their high yields relative to what they earn on safe bonds. Trouble is, people often don't appreciate that because these are stocks, they carry different risks than bonds. So what's the right way to think about such investments?
First, we need to briefly review an important point. A few weeks ago, we in the S&P High Yield Dividend Aristocrats Index (SDY) was similar to investing in a Russell 1000 Value Index fund. Our analysis showed that the fund had market exposure of 0.66 and value exposure of 0.60, along with a slightly lower expected return relative to the market (0.41 versus 0.58).
An investment in a fast-growing dividend strategy, via the Vanguard Dividend Appreciation ETF (VIG), is similar to investing in the S&P 500 Index. Our analysis found that the ETF had market exposure of 0.78 and the exact same exposures to the size (-0.12) and value (0.05) risk factors as the S&P 500. With the same loadings on size and value, and a lower beta loading, VIG has a lower expected return relative to the market (and relatively less risk).
With this in mind, let's now explore how switching out of safe fixed-income investments affects an investor's asset allocation.
Consider an investor who begins with $200,000 in assets and a 50/50 split between stocks and bonds. Having been tempted by the allure of high dividends, he sells his bonds and buys $100,000 of SDY. Given SDY's beta loading of 0.66, we can calculate that the $100,000 investment is equivalent to owning $66,000 of stocks and $34,000 of bonds. And with the 0.9 loading on the value factor, he also has a high degree of exposure to the risks of value stocks. In terms of risk, we see that his allocation has shifted from $100,000/$100,000 (50/50) to $166,000/$34,000 (83/17), and he has likely exceeded his ability, willingness, and need to take risk. Similar analysis on an investment in VIG would show a shift to an allocation of 89 percent stocks/11 percent bonds.
Because most investors can't or don't do this type of analysis, they fail to understand how much more risk they're actually accepting in return for a relatively small increase in the yield on their investments. Another mistake is to confuse yield and return. The yield of risky investments isn't guaranteed, and that's certainly true of dividends.
For instance, it wasn't destiny that the recent recession we experienced didn't turn into a full-blown depression. In fact, there were many "experts" who were making such forecasts. If that had occurred, there is no doubt that many dividend payments would have been slashed and some, if not many, would have been eliminated. Not only would investors have generated lower yields, but the values of their portfolios would have been devastated.
As hedge fund manager and author Nassim Nicholas Taleb has noted: "Lucky fools do not bear the slightest suspicion that they may be lucky fools -- by definition, they do not know that they belong to such a category. They will act as if they deserve the money. The lucky fool [is] defined as a person who benefited from a disproportionate share of luck but attributes his success to some other, generally very precise, reason."
Remember these words of wisdom the next time you're tempted by the allure of dividend-paying stocks.