Does Your Portfolio Need New Shock Absorbers?

KENTWOOD, Mich. - Aug. 13, 2015 - PRLog -- Even if you haven’t been traveling on rough roads, it’s a good idea to inspect your car’s shock absorbers regularly. Similarly, your financial advisor can help make sure that you have an appropriate amount of "shock absorbers" for your investment portfolio, too. You may need to consider adding bonds or other fixed-income investments that could improve how your portfolio handles the bumps that might be ahead in the market.

Shock absorbers are only one part of your car’s suspension system, just as fixed income is only part of your overall portfolio. And if you’ve only focused on your income, you may have substituted some high-yielding stocks for bonds. Stock dividends and bond interest both provide income, but they come from different investments that don’t play the same role when markets become volatile.

High-yield Stocks Aren’t Bonds
Over the past few years, low interest rates have been a roadblock for many investors. You may have added more dividend-paying stocks, especially if you’re relying on income from your portfolio. Although these stocks pay income, they aren’t bonds. So you can’t expect them to behave like bonds if stocks drop – historically, they’ve moved together with other stocks.

In addition, many investors have rushed into high-yield stocks. As a result, we think they have become overvalued, which could reduce their returns and make them more volatile. Instead, focus on stocks with a track record of dividend increases that are also more attractively valued.

Historically, they’ve done better than the highest-yielding stocks, and we think they’ll be better positioned if interest rates rise. Dividend-paying stocks should be a complement to your fixed-income investments – not a replacement.

Bonds Can Rise When Stocks Drop
Bonds can be “shock absorbers” for your portfolio because they generally have moved in the opposite direction from stock prices in the past. Although they won’t always rise when stocks fall, bonds have risen in each of the past nine calendar years when stocks have dropped, helping stabilize portfolio values.

If you haven’t recently reviewed how much you have invested in bonds, it may be a smaller percentage than you expected. That’s because stocks have risen pretty steadily, becoming a larger portion of your investment portfolio. As a result, your portfolio may be riskier than you thought – and you may need to add investments that have lagged behind and sell those that have become a larger portion of your portfolio. That’s called rebalancing, and it’s a way to get back to your intended investment mix, which is based on your situation, goals and risk tolerance.

Dividends Help Long-term Returns
Dividend-paying stocks work together with bonds, just like the components of your car’s suspension system work together to help improve support, performance and handling. Dividends can help grow long-term returns. Since 1926, reinvested dividends have contributed more than one-third of the total return from stocks. Remember, total return includes both dividend income and capital appreciation (the rise in a stock’s value based on market price).

Over time, dividend returns tend to be more stable than capital appreciation, as the chart shows. That’s why we recommend owning diversified U.S. and foreign dividend-paying stocks of all sizes (small, medium and large), especially those with a track record of dividend increases.

Between 1960 and 1999, dividends contributed almost 4% annually to long-term returns. Recently, their role has been smaller, and today, the S&P 500 dividend yield is about 2%. That’s one reason we think long-term returns are also likely to be somewhat lower than in the past.

Source: Morningstar, Edward Jones calculations. Capital appreciation is represented by the Ibbotson US Large Stock Cap App Index. Dividends are represented by the difference between the Ibbotson US Large Stock Total Return Index and the Ibbotson US Large Stock Cap App Index. Past performance does not guarantee future results. S&P 500 is unmanaged and not meant to depict an actual investment.

Shock-absorber Strategies
If you’ve felt squeezed by low interest rates and low dividend yields, don’t take on risk outside your comfort zone. Your financial advisor can look under the hood and help improve your portfolio’s “shock absorbers,” if needed.

Your car’s suspension system doesn’t prevent bumps from happening, and the same is true for your portfolio. The right mix of bonds and dividend-paying stocks with the potential for dividend increases won’t eliminate market volatility, but it can help you stay in control and on the road toward reaching your long-term goals.

Kate Warne, Ph.D., CFA
Investment Strategist

Past performance does not guarantee future results.

Investors should understand the risks involved of owning investments, including interest rate risk, credit risk and market risk. The value of investments fluctuates, and investors can lose some or all of their principal.

Dividends can be increased, decreased or eliminated at any point without notice.

Special risks are inherent to international investing, including those related to currency fluctuations and foreign political and economic events.