Basing a retirement planning strategy on high-yield securities can be a dangerous move.
Editor’s Note: Market Insights does not make individual stock recommendations. The companies mentioned herein are included merely to illustrate a broader point.
Freeport-McMoRan. Kinder Morgan. Anglo American. Chesapeake Energy. Glencore.
These are not just collections of letters from a random word-generating machine; they are all the names of major, widely owned stocks bought by many investors for their high dividend yields. All have cut their dividends--some eliminating them totally--in recent days or weeks. They weren’t the first to do so in this cycle, and they won’t be the last. Dividends aren’t set in stone, and many investors have just seen their income stream——the reason they bought the stock-—go poof! And therein lies the folly of chasing dividends to fund your retirement cash-flow needs.
There is a better way.
Much of the rationale for buying a “yield” investment (e.g. preferred stocks, Master Limited Partnerships, certain bonds, etc.) is that you don’t have to dip into your principal to meet expenses. You simply buy the high yield investment and spend the income generated. But this is unwise mental accounting. In the huge majority of cases, there is limited, if any, benefit to using only yield income to cover your expenses--and there are big drawbacks.
Buying only high-yield securities can create a dangerously concentrated portfolio--one omitting large sectors that typically don’t pay big dividends, like technology stocks. It can also lead you to seek out firms with higher dividend yields or bonds with higher interest rates—-which are frequently a sign of added risk. After all, the old adage, “there ain’t no such thing as a free lunch,” certainly applies to investing, and high-yield typically means higher risk.
The notion that a dividend saves you from dipping into principal is also a wee bit off when you consider it entirely ignores price movement. If you concentrate in high-yield stocks, eschewing diversification, you risk dipping into your principal by far more than you might imagine.
We always encourage people not to think of yield alone in their retirement planning strategy. Or price alone. It is the combined movement-—total return-—that impacts your portfolio most. When you take into account total return, you find that you are empowered to invest in anything—-and you can harvest the cash flow you need either from cash on hand, dividends, interest or, yes, by selling some shares. It’s often a good idea for retirees to eliminate the mental accounting that places dividends in one bucket and principal in another.