With interest rates continuing to hover at historically low levels, investors looking for income are understandably frustrated. Perhaps it should come as no surprise, then, that more people are recommending dividend stocks as an alternative to bonds, CDs, or even savings accounts. See here for an example.
As such articles sometimes (but not always) point out, stocks are not bonds, and they’re sure as heck not CDs or savings accounts. Stocks have an entirely different risk profile and, no matter how high their yield, they’re not a reasonable replacement for fixed income investments or cash equivalents.
Think about it… If you’ve been holding cash, there’s probably a good reason for it. And that reason is almost certainly not compatible with putting your money in the stock market.
Yes, high yield stocks can be good income producers, but they can also be very volatile. Don’t believe me? Check this out…
From it’s peak in the summer of 2007 to it’s low point in the spring of 2009, the S&P Dividend ETF (SDY) plummeted from $65.89 to $27.53 — a loss of 58.2% in less than two years. As of today, it’s back up to a bit over $55, which is still more than 15% below it’s peak.
Sure, it currently yields a little over 3.1%, and yes, some dividend stocks yield more or perform better than average (though others yield less and/or perform worse). Regardless… Yikes! Does that sound like a reasonable alternative for holding your cash?
Here’s my advice… If you need (or want) to hold a cash equivalent in your portfolio, then hold your nose and do so. There is no such thing as a free lunch. If you chase higher yields, you increase your risk.
Yes, inflation is a concern, and I’m not suggesting that you shun the stock market in favor of the alternatives. But don’t go putting money that you might need in the near term in the stock market simply because your savings account is paying a pittance.
6 Responses to “Stocks are Not Bonds, CDs, or Savings Accounts”
I second Nickel’s philosophy. You need tiered savings – to balance out life’s risks. You need extremely liquid (and fdic insured) savings for short term needs….think checking accounts here. And then go up to riskier investments from there. I personally am holding 6 months of savings (living expenses) in FDIC insured savings accounts.
Stock investments are only for money I will absolutely not touch until retirement, which is 30 years from now (for me). I don’t see the stock market as a way to get rich. I look at it as a place to store wealth for the long term inflation hedge, and nothing more.
Peter: I have no problem with the stock market in general, or with dividend stocks in particular. BUT… If you’re using them in place of cash, you’re making a big mistake. The primary reason for holding cash is that you might need to access it in a pinch. So if you toss that your cash into the market in search of a marginally higher yield, you’re exposing yourself to tremendous market risk, and you may wind up being forced to sell at just the wrong moment.
In short, negative real returns are (imho) a necessary evil for money that you need access to in the near term. What I was railing against in this article was that dividend stocks are a reasonable alternative to a bank account for your cash needs. I’ve seen this argument made more than once, and it’s simply wrong-headed (again, imho).
I followed the link in your example – S&P Dividend ETF (SDY) – to see what the income stream from this looked like over the period of the big loss in asset value (2007 to 2009). I expanded the chart out to the last 5 years and last 10 years, and it seemed to me that, if I was depending on this investment as a source of income, it isn’t that bad. Sure, the paper loss would have been gut-wrenching, but that too has recovered significantly. And the annual income seems better than I see from so-called safe investments like Treasury bills, money-market accounts and the like. I don’t imagine 1- to 2-year CDs have had yields better than the inflation rate – yes, that means negative returns in real terms.
The quarterly dividends do vary – generally in the range 30 to 60 cents, with the following two exceptions:
2007 Q4 dividend was $1.38 and 2009 Q1 dividend was 0. Could you provide some insight into what caused these two significant deviations.
I’d say that income from this kind of investment isn’t as steady as salary from a steady job, but it’s probably less volatile than typical income for people like farmers, fishermen, and snow-removal guys.
Bonds represent a contractual obligation of the borrower to pay you back, with a known (up front) ROR. The risks are the borrower goes bankrupt (which wipes out the shareholders before the bond holders), and the unknown future inflation rate.
CDs are normally FDIC insured (to certain limits) – practically risk free (hence pay less interest than bonds).
Stocks, the riskiest if the three, represent your part ownership of a company. You theoretically (part) own the assets, profits, and are on hook for the liabilities (debts/bonds) — worst case, you lose 100% of your investment, otherwise the gains are unlimited. Some companies will pay a dividend (out of profits after paying the CEO/executives millions), so you make money that way. Otherwise you make money as a shareholder buy selling your shares to someone else for a higher price than you purchased at (bigger sucker).
No stocks are certainly NOT bonds. There is no such thing as a risk free investment. All investments have risk. Some aren’t as obvious as others.
Right now it’s damned if you do, damned if you don’t. Get a 5 Year CD that earns less than 2% APR, which is the targeted (but currently much higher) inflation rate the FED has set, or invest in higher risk bonds and stocks with dividends?
Let’s not forget if/when the rates do rise what will happen to mutual fund bond shares. Bond holders can get burned in a massive way.
So either lose with real negative interest rates for any government issued bond, or CD, or choose many dividend stocks that have had a history of increasing their dividends for over thirty years (dividend aristocrats) and pay more than 3%?
Unfortunately most dividend paying investments are expensive right now because of this multi-year 0% FED rate.
Here are your options all are a crowed trade right now:
– Corporate bonds
– High Yield bonds
– Muni bonds
– Foreign bonds
– Dividend stocks
– P2P Lending (new to the game)
At least in my opinion the lesser evils to add new monies to are: muni bonds, REITs and dividend stocks.
There is definitely risk to holding dividend stocks. I think they are a reasonable investment class though for a 5 year period. I don’t think you will see as much fluctuation between the solid dividend producing stocks like ATT & 3M when compared with tech stocks like Pandora or Facebook…