Smooth Out The Stock Market Roller-Coaster
Income generation is not a very sexy investment topic. Investment talk shows and websites are much more interested to spot the next Apple than they are with portfolio income yield; but when it comes to retirement investments, portfolio income plays a dual role: it can provide liquidity for living expenses while also acting as an important source of portfolio stability.
The value of portfolio income generation for stability
Every investor who owns stocks should recognize that they can go up or down in price and, at times, the roller coaster can be quite dizzying. However, if you focus on income generation, you may find the ride much smoother.
To illustrate this, consider the two great bear markets of the 21st century (so far, anyway). One accompanied the global financial crisis and spanned from September 30, 2007 through the first quarter of 2009. The other was marked by the collapse of dot-com stocks and spanned from March 31, 2000 through September 30, 2002.
In the case of the dot-com collapse, the price level of the S&P 500 fell by 45.6 percent from high point to low point. For investors in general and retirees in particular, having the value of your investments fall by almost half could be disastrous, but there was a silver lining. At its worst, annual dividend production of the S&P 500 dropped by just 6.4 percent during this bear market.
So, while prices experienced a severe setback, investors concerned primarily with the income generation of their portfolios felt a much milder impact. As this shows, portfolio income can be a huge stabilizing factor – especially for retiree portfolios meant to provide income during retirement but which don’t have as long to wait for prices to recover.
The bear market that accompanied the financial crisis was even harsher; but, still, portfolio income provided some measure of stability. In this case, the S&P 500 dropped by 47.7 percent. At its worst, 12-month dividend generation of the S&P 500 dropped by 24.1 percent. That was worse than in the prior bear market, but yet only about half the decline in prices.
Here’s an interesting connection between those bear markets that underscores the steadying impact that income generation can have. The 2007-2009 bear market was so severe that the low point for the S&P 500 was actually beneath the low point of the previous bear market about seven years earlier. However, even at its low point, S&P 500 dividend production in that later bear market remained nearly 40 percent higher than at the low point of the previous bear market.
In short, an investor focused on income generation would have had a relatively smooth ride through the roller coaster of these two bear markets.
The bond price and yield trade-off
While bonds are generally considered safer than stocks, even their prices are subject to some jarring ups and downs. Here too, though, income generation provides some measure of stability.
The mechanism of bonds is that, as their prices fall, their income yields generally rise and vice versa. So during bear markets for bonds, investors at least have the partial consolation of rising income yields. For retirees dependent on that income, that should be a key source of comfort even as prices fall, especially for high-quality bonds with low default risk.
Unlike most bonds which have fixed interest payments, stock dividends are not set in stone. Companies are free to raise and lower them depending on conditions – though they try to keep them somewhat stable. As noted previously, dividends on stocks did not decline nearly as much as prices during the last two bear markets; so to some extent, the dynamic of dividend yields behaved similarly to the dynamic of bond yields – as prices fell, dividend yields rose.
This dynamic is especially important today, as stocks may be playing a particularly significant income-generation role in many portfolios. The current dividend yield on the S&P 500 is 1.94 percent, not far off from the 30-year average of 2.10 percent. However, 10-year Treasury bonds today are yielding about 2.6 percent, a far cry from their 30-year average of 4.7 percent.
With bonds providing less income than usual, the income-generation ability of stocks becomes more important. While this may lead investors to a more risky stock/bond mix, the dynamics discussed in this article should take some of the edge off that risk for income-oriented investors.
So, while finding the next high-flier tends to dominate investment chatter, focusing on portfolio income is a key to creating an all-weather investment program that can serve a valuable purpose in good times while creating relative stability in the bad times.
Frequently Asked Questions
Q: Should a senior over the age of 80 have any money at risk in the stock market? I’ve heard some people use an “80/20” rule in that situation.
A: As simple as it is, there is some merit to using something like an 80/20 rule. Still, it’s important to remember that those are broad guidelines, and thus are not suited to the specifics of every situation.
The 80/20 rule you are probably referring to is a guideline for adjusting asset allocation as a person ages. Essentially, it uses the person’s age to set the percentage of lower-risk assets, such as savings accounts and bonds. So, a 30-year-old would have an asset allocation of 70 percent stocks, with 30 percent in bonds and savings accounts; a 40-year-old would have 60 percent in stocks, etc. Under that system, an 80-year-old would have 20 percent in stocks, with the remaining 80 percent in bonds and savings accounts.
The value of that kind of system is two-fold: It prompts people to adjust their asset allocation over time, which they often forget to do, and it guides them toward more conservative allocations as they grow older. Both are valid principles. However, this is a very broad, one-size-fits-all kind of tool, so it’s worth thinking through how your particular situation might be different.
First, consider the role of stocks in a portfolio. For a younger person, they can help retirement savings grow. For an older person, their role is more as a cushion against inflation. People with a set amount of financial resources are especially vulnerable to inflation, and they may have enough years left for inflation to take a serious toll.
One of the mistakes people make is underestimating how long they are likely to live in retirement. The average life expectancy in the U.S. may be 78.5 years (according to the Centers for Disease Control), but if a person makes it to age 80, life expectancy extends for 9.2 more years.
This is why you don’t want to get too conservative too quickly. In fact, for some 80-year-olds, 20 percent in stocks might not be enough. If you have ample means to live on, and are concerned with leaving some assets behind as a legacy, either for the benefit of relatives or charity, then you might want to have a higher percentage in stocks.
In that situation, you can mentally separate two portions of your money: the portion you will need to live on, and the portion you expect to leave behind. The portion you need to live on should have the conservative allocation associated with an 80-year-old, but the portion you expect to leave behind is earmarked for the future, and can afford a more aggressive asset allocation.
Q: Do you recommend silver bullion for a portfolio?
A: Buying silver for a portfolio is an interesting suggestion, because with gold prices having run up so wildly, it may seem worth looking into whether silver might be a more reasonably-priced alternative. It turns out though, that silver has been riding much the same speculative wave as gold over the past decade. Spot silver prices increased roughly ten-fold from 2001 to 2011.
People tend to buy gold and silver as a hedge – against inflation, or the notion of a world-wide catastrophe. If you think it through though, you may find reason to question whether either metal really has the characteristics of a true hedge against those outcomes. Consider the following:
- As an inflation hedge, do gold and silver really represent the characteristics that drive inflation? They are not tied to energy, food, construction materials, or labor costs. In other words, they types of real-world inflation that can affect you could easily soar while leaving gold and silver behind.
- Will gold and silver retain value in a global financial collapse? It’s hard to imagine that commodities that have been so driven by financial speculation will retain their value in a financial meltdown. Also, if you are buying futures contracts or various securities linked to gold and silver, as opposed to possessing those metals yourself, you are exposed to the same financial system risks as you would be if you owned stocks and bonds.
With that being said, precious metals may have a place in a well-diversified portfolio, but only as a relatively small percentage. Just remember that they produce absolutely no income. If prices level off, or decline, that lack of income will make even today’s low rates on savings accounts, CDs, and money market accounts start to look attractive again.
More resources on investing:
- How much do you need to save for retirement? Try our retirement savings calculator
- Portfolio rebalancing: Rebalancing an investment portfolio
More resources on managing CD investments:
- What inflation is doing to your CD rates
- Know your CD’s inflation-adjusted value at maturity – try our new CD inflation calculator
- Compare CD rates
