Retired investors seeking high income to live off of during retirement, face greater challenges today than almost ever before. The days of high yields available from bonds and other fixed income vehicles are long gone. Consequently, generating an adequate level of current income on retirement portfolios is difficult to say the least. This is especially tricky for those investors with a low tolerance for risk.
Moreover, there’s no question that equity investments technically carry more risk than fixed income investments. This is widely acknowledged, and in the general sense, an unarguable position. However, this begs the question as to exactly how much more risk do equity investments carry versus fixed income investments? In other words, is the risk of investing in equities (common stocks) versus a fixed income instrument (bonds, CDs etc.) 100 % more risky, 50% more risky, 25% more risky, 10% more risky etc.?
These seem like important questions to ask and have answered. However, I have personally not come across any truly cogent analysis that precisely quantifies the greater risk of a stock or equity over a bond or other fixed income instruments. But with this said, my 40+ years of experience investing in equities leads me to conclude that most people overestimate the greater level of risk that equities possess. This is especially true regarding equities with long histories of paying dividends. Yes, I agree that there is greater risk, but I do not agree that the risk of owning equities is as great as many people contend or believe.
Equity Risk versus Fixed Income Risk
What complicates the matter even more is how risk itself is defined, thought of or interpreted. At the extreme, the question of risk implies the possibility of total loss. Although that possibility does exist, and in fact has occasionally occurred in the real world, I believe that the risk of total loss is rare enough to not be a major concern. Moreover, I believe this extreme risk can be mitigated with even modest due diligence and monitoring. Perhaps not totally eliminated, but certainly diminished.
Moreover, when evaluating the risk of investing in stocks, many investors are referencing price volatility. And usually, by volatility they mean the risk of the price of the stock dropping. However, I contend that if the price of a high-quality company does drop, but the underlying fundamentals of the business remain strong, that it represents opportunity rather than risk. About a year ago I wrote extensively on the subject found here.
Additionally, I also authored a two-part series on how investors can mitigate the investment risk associated with owning stocks. In part 1 I elaborated more on the concept of volatility risk.
And then, in part 2 I expanded my discussion on risk to include numerous other risks associated with investing in common stocks.
And, for those interested in learning more about the volatility aspect of risk, I authored another article in April 2012.
The primary point I expressed in this last article is my contention that it is not the volatility itself that establishes the risk of owning a stock; rather the greater risk rests in how people react to that volatility. The following excerpts from a comment shared by a regular reader of mine on my most recent article nicely summarizes this point.
“my objective is to earn an income stream that is reliable, predictable and increasing. It’s all about the income stream, what I refer to as my pension from Mr Market. I need to know what that pension is going to pay me in the distribution phase of my life. I can do that with dividend growth investing….
This year has seen the market correct to where it is down for the year. The Dow was down over 5% in January alone. Although the market continues to fall, my pension payment continues to rise. I will establish an all-time high in dividend income this month, and it has nothing to do with share prices. Market falls, I get a pay raise…..”
As I previously stated, equity risk is most commonly associated with price volatility and the accompanying potential for loss. However, for retired investors seeking income from their portfolios, there is also the issue of income risk. As it is with most types of risk, this is also a multifaceted concept. For example, there is the risk that your income will not keep up with inflation. Dividend growth stocks with a long history of increasing their dividends do mitigate some or even most of this risk, while a fixed income investment with a constant yield does not.
In contrast, there is the risk of your income falling on an absolute basis. With equities, this would occur with a dividend cut, or worse yet, a total elimination of the dividend. Note: As I was putting the finishing touches on this article, the oil and gas storage MLP, Boardwalk Pipeline Partners, LP (NYSE:BWP) did in fact cut their distribution by approximately 81%, and their stock price accordingly fell by approximately 40%. Although I do not consider this a high quality blue-chip dividend paying stock in the caliber of a Johnson & Johnson (NYSE:JNJ), The Coca-Cola Company (NYSE:KO) or The Procter & Gamble Company (NYSE:PG), it does put a spotlight on the potential income (and volatility) risk of investing in high yielding equities.
In contrast, high-quality fixed income investments such as government bonds, virtually eliminate this risk altogether, but offer little or no protection against inflation. On the other hand, extremely high quality blue-chip dividend paying stocks such as found on David Fish’s lists of Champions, Contenders and Challengers or the Standard & Poor’s Dividend Aristocrats, have historically at least, provided a high level of protection against income risk.
Receiving an adequate level of income on your portfolio is another aspect of risk that should be considered. In the past, one of the most salient features of a bond was high yield. Consequently, it made sense to balance your portfolio with stocks and bonds because the yield advantage from bonds was high enough and the spread large enough to compensate for the lack of inflation risk. But as I’ve written about before, the interest income rates available from bonds and other fixed income instruments are not normal today, nor are they high enough.
With today’s extreme, and in the minds of many, contrived low level of interest rates, the risk profile of bonds and fixed income are far from typical. More simply stated, the currently extreme low level of interest offered by bonds and other fixed income instruments have dramatically altered, and I contend, increased their risk profile. In essence, this has narrowed the risk profile between stocks and bonds, and especially so for higher-yielding dividend stocks. Since bonds no longer offer a significant yield advantage, inflation risk has increased and the scales are currently tipping more in favor of higher-yielding dividend paying stocks, at least in my humble opinion.
Moreover, I think it’s important that investors recognize that bond portfolios are also subject to price volatility. Although it is true that if you hold a bond to maturity you will eventually receive its par value. However, during the duration of the bond, the current market