Systematic Relative Strength

Dividends are all the rage nowadays, especially since dividend stocks did very well last year. We like dividends as much as the next guy. Heck, we provide portfolios for a series of dividend UITs at First Trust. But, as a recent Wall Street Journal article makes clear, dividend stocks are not bonds.

For many investors who crave steady income, bonds don’t look as good as they used to.

With U.S. Treasury yields languishing near historic lows, some people believe they’ve found a great alternative: dividend-paying stocks or dividend-focused mutual funds.

Many investment pros say it can be a reasonable move for at least part of an income-oriented portfolio. But they caution that investors need to understand the risks. The most basic concern: Equities don’t behave the way bonds do, and investors face a much greater chance of capital losses with stocks and stock funds.

“People may not appreciate that moving from bonds to stocks is a major change in asset allocation,” says Joseph Davis, chief economist and principal at Vanguard Group.

Investors should also remember that dividend-paying stocks don’t always behave like other stocks, either. Dividend payers are often larger, established companies—which means they often aren’t perceived to have the same potential for earnings and revenue growth as smaller firms. When the rest of the market is booming, dividend payers are often lagging behind the crowd.

It’s not that dividend stocks are a bad thing—far from it. But they do act like stocks when the market sells off, and they don’t act like growth stocks when the market is roaring. If you are using dividend stocks as part of your allocation, you need to be realistic about how they will behave in the marketplace. If you sell out because they aren’t going up as much as the rest of your portfolio in a rally, you’re on the wrong track. And if you panic and sell out because they drop 15% during a market correction, you’re missing the boat. These behavioral characteristics are things you should understand before you add them to your portfolio.

That advice is not limited to dividend stocks—it is true for every investment you make. Know what can reasonably be expected and don’t be shocked when it happens!

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Source: Wall Street Journal/Morningstar