Diversification is key to the success of any retirement planning strategy. Learn some of the pitfalls to avoid when planning the future.
Dividend-paying stocks and other interest-bearing securities can play a useful role in a properly diversified retirement investment portfolio, and they are an entirely valid way to generate needed cash. But many retirees turn into “yield seekers,” people who solely seek out investments that pay high dividends or interest rates. This can be a dangerous way to fund a retirement as it eliminates the diversity from a well-balanced portfolio.
Two common products folks make this mistake with are Master Limited Partnerships and preferred stocks, which we will discuss later.
MORE: Do you know how much your retirement will cost? Do you know how to generate the retirement income you’ll need? The Definitive Guide to Retirement Income will help you find answers to these and other important questions.
Diversification in Retirement Planning
Diversification is essentially spreading your assets across an array of stocks in order to limit your risk.
There are several things to think about when creating a diverse portfolio:
- Don’t pile into any one stock with a huge portion of your portfolio; it’s too risky!
- Be wary of sector concentration. This will limit the risk of every piece of your portfolio reacting similarly when only one factor changes—e.g., oil prices or interest rates.
- Don’t be a yield seeker. The trouble for “yield seekers” is that high-yielding investments often cluster into groups by sector and style, limiting the ability to get appropriate diversification.
Master Limited Partnerships
If you seek cash flow, your broker might pitch you on investments called Master Limited Partnerships, or MLPs. MLPs have become extremely popular in recent years, and there is nothing wrong with MLPs per se. But you must understand what you’re buying.
These securities are overwhelmingly concentrated in the Energy sector and they trade nearly exactly like Energy stocks.i (Exhibit 1) They are also extremely sensitive to oil prices—hence why MLPs are down massively. (Exhibit 2)
Exhibit 1: MLPs are Energy-Concentrated
Source: FactSet, as of 11/19/2015. Alerian MLP Index sector weights.
Exhibit 2: MLPs are Oil-Price Sensitive
Source: FactSet, as of 11/19/2015. West Texas Intermediate crude oil price, S&P 500 Energy sector with reinvested dividends and Alerian MLP index with reinvested dividends, 12/31/2013 – 11/18/2015.
So if you buy MLPs, you must add them to your weighting in the Energy sector. Said differently, if you put 15% of your assets in MLPs and the other 85% in an S&P 500 Index Fund, your portfolio is 21% Energy—more than three times its weight in the US stock market (7.1%).ii This greatly exposes you to trends in the Energy sector—nice when Energy is hot, but quite detrimental to your returns over the past year or so.
Your broker may also discuss “preferred stocks” as something to add to your retirement planning strategy. However, with preferred stocks, the same logic applies.iii Preferred stocks are a common means of funding for banks—junior to bonded debt, senior to common stocks. Given their bond-like aspects, there is some tendency for preferred stocks to be negatively affected by rising interest rates, although this isn’t the biggest problem.
The problem is, the vast sector concentration means preferred stocks tend to be heavily influenced by factors affecting bank health. Exhibit 3 shows the sector concentration of the Merrill Lynch Preferred Fixed Rate Index. Exhibit 4 shows how this index behaved during 2008’s global financial crisis (including reinvested dividends) to illustrate the effect of this sector concentration.
Exhibit 3: Sector Composition of the BofA/Merrill Lynch Preferred Fixed Rate Index
Source: Bloomberg, as of 10/27/2014
Exhibit 4: Preferreds Acted Like Stocks During the Financial Crisis
Source: FactSet, as of 11/18/2015. BofA/Merrill Lynch Fixed Rate Preferred Index and S&P 500 Index both including reinvested dividends, 12/31/2006 – 12/31/2009.
Seeking yield often stems from some investors’ aversion to selling securities to generate needed cash flow. They believe cash flow should come from dividends and interest—“income”—and the principal portion should go untouched. But your portfolio is best understood as a pool of money that is all working toward your goals. Segregating aspects of it in your mind is a false distinction; a false distinction that could unnecessarily increase risk.
Fisher Investments believes in creating what we call “homegrown dividends” to meet withdrawal needs. This retirement planning strategy can include dividend and interest income, but would likely also include sales of securities from time to time. This allows us to manage how the cash flow is generated and, if your retirement account is taxable (non-IRA) account, your potential tax liability associated with withdrawals may be lower if you sell securities than if you rely solely on high-yielding securities.
i You should also be aware there are positive and negative tax aspects to owning MLPs, including the possibility you are taxed on distributions even if you own them in a retirement account like an IRA.
ii Source: FactSet, as of 11/19/2015. S&P 500 Energy sector weight.
iii We use the scare quotes because we don’t really believe they are so very preferential. The only thing is a preferred shareholder is more likely than a typical shareholder to receive compensation when a firm goes bankrupt, but we doubt that is much consolation.