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Are dividend stocks the best path to income in a bear market? | Financial advisors

Capital preservation is paramount for investors nearing retirement or in retirement, so it is also a priority for financial advisors. Large drawdowns during a bear market can affect savers’ ability to retire comfortably. For some investors, portfolio declines can mean postponing retirement plans or even returning to work.

Traditionally, a source of income for retirees has been dividend-paying stocks. But let’s say an investor owns a stock that has fallen significantly but is still paying a dividend. Ford Motor Co. (F) is a good example: the stock is down 25.3% this year to August 1. Its 12-month dividend yield is 2.6%. Sure, some return is better than none, but you’re only making a fraction of the difference between the old and current stock valuation.

This is causing some financial advisors to rethink their approach to dividend investing. Others continue to use dividend payers as part of a strategy to outperform the broader market.

The path to stability for client portfolios in a bear market doesn’t have to be a path reserved for dividend-paying stocks. Read on for more strategies used by financial advisors to generate revenue and returns for clients in challenging economic environments:

  • Regular dividend payers.
  • How to think about options.
  • Another way to preserve capital.

Regular dividend payers

“My company used a dividend strategy this year and beat the broad indices with it,” says Jonathan Howard, financial planner at SeaCure Advisors in Lexington, Kentucky. “This has been by far our most successful investment strategy this year.”

For portfolios in general, says Howard, dividends act as a buffer against losses. Of course, that assumes higher returns and lower losses than a single stock like Ford would have provided year-to-date.

“If a portfolio’s dividend yield is 4% and stock prices are down 10% year over year, the total return is -6%,” Howard says. “Dividends help soften the impact of economic downturns.”

Another important factor for investors: companies that pay regular and reliable dividends tend to be high value companies. “Their books are good and their stock prices are trading below where they should be based on fundamentals,” Howard said.

This year, these large-cap value companies have not suffered the blows that the broader market has suffered. This is true even when you compare these value stocks to the Barclays US Aggregate Enhanced Yield Index, generally considered a proxy for the US bond market.

John Robinson, founder of Nest Egg Guru in Honolulu, takes a combination approach to boosting customer portfolios in a bear market. It uses individual certificates of deposit as well as treasury bills for the fixed income portion of client portfolios. It also uses index fund ETFs, or exchange-traded funds, for the equity portion, especially in retirement accounts.

“Outside of retirement accounts, I often help clients develop passive income streams by investing in companies that grow their dividends each year at a rate above inflation,” he says.

Robinson explains to clients that this strategy has nothing to do with stock picking, but rather is a way to pick companies that are healthy enough not just to pay dividends, but to grow those payouts each year by at least 5%. at 7%.

“It’s important to note that dividend yield is not a primary selection criteria,” he says. “High dividend yields often signal slow dividend growth or potential dividend cuts. These days, yields of 2% to 4% are the norm for companies that meet our other screening criteria.”

Other criteria considered by Robinson include:

  • Price/earnings ratio less than 20 times earnings.
  • Dividend payout ratio of 50% or less (except for utilities).
  • Five-year average dividend growth rate of 5% or more.

It will sell a stock if a company cuts its dividend or has three consecutive years of declining profits and revenue.

How to think about options

Howard also uses covered call strategies to generate income. “However, the income will be taxed as ordinary income due to the holding period rules on option income,” Howard said. “While a diversified and reliable dividend portfolio can consistently generate dividends in the 3% to 5% range, covered call portfolios can generate income in the 7% to 12% range. .”

Investors can use this higher income to offset additional taxes, Howard says.

Not all of Howard’s clients initially buy into the idea of ​​options, but he takes the time to explain the strategy using an illustration they may be more familiar with. “My experience is that a lot of people are just scared off by the novelty of the idea and the complexity of it,” he says.

“Our society likes to think of it as if you were renting out your stocks like you would investing in real estate,” he explains. “Someone is paying you for the right to maybe one day buy your shares the same way you would get rental income from a tenant in a building.”

Another way to preserve capital

Another somewhat controversial approach to generating returns during a bear market is to use inverse ETFs, which are designed to move in the opposite direction to their underlying benchmark. For example, the ProShares Short S&P500 ETF (SH) provides inverse exposure to the S&P 500 Index.

“I’m a fan of using inverse ETFs to add downside protection to stock portfolios, especially when someone owns a lot of low-base stocks with large, unrealized gains they don’t. doesn’t want to sell,” says Jordan Kahn, Chief Investment Officer. agent at HCR Wealth Advisors in Los Angeles.

This strategy can help reduce an investor’s overall market exposure and add hedging to portfolios, he says.

However, Kahn cautions against using leveraged inverse ETFs, which yield two or three times the inverse of their index. “Stay away from leveraged ETFs. They have novel pricing mechanisms that can lead to significant tracking errors relative to the underlying indices they short,” he says. “Also, I would consider them an alternative strategy, but not necessarily a dividend replacement, as they provide no dividend income.”

“Bear market rules apply. This means stricter risk management for beginners and always using stop-losses to protect capital when you go wrong,” he says.

He adds that investors should also be comfortable holding higher than normal cash balances, while patiently waiting for a more sustainable market bottom.

“The last 13 years have been driven by quantitative easing, ultra-loose monetary policy and very low inflation,” Kahn said. “The current environment is fundamentally the exact opposite. So stock picking is becoming more important, as is paying attention to valuations. Go back to basics. Stock picking isn’t meant to be easy, but it can be done if you put in the work.”