The downside of using dividend-paying stocks to create an income stream

In a search for yield in a low rate environment, what’s the downside to using dividend paying stocks to create an income stream to fund retirement spending? Colleen Jaconetti of Vanguard Investment Strategy Group and Kahlilah Dowe of Vanguard Personal Advisor Services® say this strategy adds significantly higher risk.


Amy Chain: Colleen, I’m going to toss this question to you. This one’s a little timely. Given the historic low interest rates, what are the downsides of creating an income stream from a portfolio of dividend-producing stocks?

Colleen Jaconetti: So I guess to answer this question, I think we really have to start with the premise that you have a broadly diversified portfolio and that you selected your asset allocation based on your time horizon, risk tolerance, and goals. So you’re in the right allocation, and you’re diversified. So from there, if you’re going to overweight dividend-paying stocks, the real question is where are you going to take it from? So you really have two choices, right? If you take it from the bond portion of the portfolio, many retirees have bonds in their portfolio to dampen the volatility of stocks. So if you shift some of your broadly diversified bond portfolio to overweight dividend-paying stocks, you’re really changing your asset allocation, right, and taking on more risk. So that’s just one thing to consider there. And then if you actually shift some of your broadly diversified stock portfolio to overweight the dividend-paying stocks, you’re, again, going to take on more risk, but it’s more because you’ll be overweighting value stocks. So value stocks typically are the ones that pay dividends. So what will happen is you’re going to end up having a more highly concentrated portfolio. So I think many retirees don’t realize, including my own mother, that if you shift away from a broadly diversified portfolio, for the sole purpose of increasing the cash flow from the portfolio, your principal value could actually be at higher risk than if you just took the money that you needed from the portfolio.

Amy Chain: That’s great. Kahlilah, anything to add?

Kahlilah Dowe: Yes, and I think the interesting thing is many of the clients who I work with, who are considering this strategy or have adopted this strategy, you know, when we think of stocks, we think of mainly growth, right? We look to stocks to provide the growth in the portfolio. Many of the investors who are pursuing that sort of strategy really aren’t at that stage where they’re looking for growth. And when I ask, that’s the response. It’s, “No, I’m looking for more income and more preservation, not so much growth.” And so, to your point, Colleen, I try and steer them away from that approach because you could end up with a portfolio that looks like an accumulator or someone who is still trying to accumulate assets for retirement, as opposed to someone who’s already in retirement. So I try to steer investors away from that approach because most of the times they’re taking on risk that they don’t realize is there. And the example that I draw on is, you know, if you think about dividend-paying stocks, 2008 when the market was down significantly, they were down with the overall stock market. And I think that’s important to consider because they sometimes get tagged as income-producing investments. So I just want to be clear that truly it’s a stock, and we expect that stocks will be volatile.

Amy Chain: So it could affect the principal portion of a portfolio, even if there’s income being generated.

Kahlilah Dowe: Correct. Exactly, exactly.

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