Should retirement portfolios tilt toward dividend stocks?

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Browser
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Should retirement portfolios tilt toward dividend stocks?

Post by Browser » Tue Aug 27, 2013 1:22 pm

An overlooked risk factor affecting a safe withdrawal rate (SWR) strategy in retirement is Estimation Risk. Estimation risk is the error in predicting future asset returns and the volatility of those returns. Obviously, fixed-income assets such as bonds and CDs have less estimation risk than stocks and consequently are favored by both retirement investors and advisors, as illustrated by the well-known "age in bonds" rule. However, this presents a conundrum to retirement investors. On the one hand, there is a large body of existing research on SWR that concludes that retirees should maintain a relatively high allocation to broadly diversified equities in order to support desired or required SWRs. But on the other hand, such portfolios are characterized by high estimation risk and, therefore, holding a high degree of confidence in a SWR (such as the iconic 4% rule) based on the expected returns from such portfolios, especially during major stock market downdrafts, cannot be readily justified.

One strategy that is often preferred by retirees is to tilt toward income-producing, or dividend-paying stocks, instead of investing more broadly in the stock market. However, there have been some stong criticisms of following this strategy, such as this one from Larry Swedroe
the popularity of high-dividend strategies has driven the valuations to levels that certainly are no longer value-oriented. This changes the nature of the fund in terms of what investors should expect in terms of returns.

Unfortunately, it's almost a certainty that most investors are unaware of this impact. You know longer have this excuse. As I warned yesterday, buyer beware.
Despite the criticisms of the dividend stock strategy, there may be another reason to consider dividend stocks in a retirement decumulation portfolio -- lower estimation risk. It may be that there is less uncertainty in estimating the volatility and returns of high dividend stocks than for the broad equity market. First, since dividends provide a relatively non-volatile floor for total equity returns, this implies there should be relatively less uncertainty about their future returns. Additionally, it also seems to be the case that the earnings of higher dividend-paying companies are more stable than for stocks in general, as discussed in this article, and this also implies lower estimation risk.
We find that the reported earnings of dividend-paying firms are more persistent than those of other firms and that this relation is remarkably stable over time. We also find that dividend payers are less likely to report losses and those losses that they do report tend to be transitory losses driven by special items.
If higher dividend-paying stocks do in fact have lower estimation risk than stocks in general, then this is an important factor for retirees to consider who are trying to
optimize a SWR strategy for their individual situation.

This topic is examined in some detail in this paper from Geoff Considine. He refers to the strategy of investing in the broad stock market as the total-return strategy, and the strategy of investing in dividend stocks as the income-oriented strategy. He summarizes his conclusions as follows:
1. Total-return-oriented portfolios have higher expected return and higher estimation
error than income-oriented portfolios.

2. The SWRs for total-return strategies are higher than for income strategies, but they
are more likely to require revisions and adjustments due to changes in the projected
equity risk premium.

3. Income-oriented strategies will provide lower SWRs but with a lower probability of
downward adjustments to the withdrawal rate, because they are less likely to
require substantial selling into a declining market (one of the worst scenarios for
retirees).

4. Portfolios designed to optimize total return but with a threshold income level that
must be satisfied (as in my third scenario above) are a compromise solution.
http://advisorperspectives.com/newslett ... _Rates.php
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Re: Should retirement portfolios tilt toward dividend stocks

Post by bertilak » Tue Aug 27, 2013 2:41 pm

I have not heard the term "estimation risk" before but I think I understand it. I have said that a dividend strategy is akin to a managed payout where the investor relies on the companies' management to determine a safe payout rate and pay that out as a dividend. Such companies tend to pick payout rates (dividends) that they believe they can safely and (somewhat) reliably sustain. The company management can use all the inside information it has to establish that dividend.

I believe this is the true "safe withdrawal rate" that will not exhaust your investment, even after 30 years. I am willing to accept a lower return for this level of security.

When I look at funds like Wellington and Wellesely I think that maybe I'm not giving up much return after all. I do note that they are not "pure" dividend strategy funds but they seem to have established a balance that looks good to me.
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Re: Should retirement portfolios tilt toward dividend stocks

Post by The Wizard » Tue Aug 27, 2013 2:51 pm

Interesting. Once I have excess retirement income in a few years, after I've paid off my mortgage, I think I'll start accumulating one of the VG dividend funds in my after-tax portfolio. There could be worse things to have...
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Re: Should retirement portfolios tilt toward dividend stocks

Post by Browser » Thu Aug 29, 2013 9:33 am

Another consideration to bear in mind is that holding dividend stocks will allow the individual to sell fewer equity shares in order to support his income withdrawals, since more of his income needs can be funded from dividends. This would be especially important during bear markets, since the individual would be forced to liquidate fewer shares at depressed prices.

This factor has been overlooked in examining the results of historical SWR studies, which are largely based on data from periods in which stock dividends were considerably higher than they are today. It seems doubtful that historical SWRs could be supported with today's dividend yields, since the rate of principal depletion would be significantly higher.
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Re: Should retirement portfolios tilt toward dividend stocks

Post by wintermute » Thu Aug 29, 2013 9:58 am

Perhaps a reasonable alternative to a dividend paying stocks (given their fad-induced valuations) may be to synthesize them. Buy a long term corp bond fund and non-dividend paying low beta stocks. The LT corp fund could be one that buys-and-holds to near maturity (to sell above par, if possible). This separation would also allow for the usual boglehead tax optimization by holding the bond fund in tax-deferred and the stocks in taxable. I don't know if any useful funds exist that fit those descriptions, however.

You could also start a holding company or closed-end fund that does this and sells itself as synthetic dividend-stock, convince dividend funds to buy it, and try to profit from this tax inefficient fad. :happy

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Re: Should retirement portfolios tilt toward dividend stocks

Post by wintermute » Thu Aug 29, 2013 11:12 am

Browser wrote:This factor has been overlooked in examining the results of historical SWR studies, which are largely based on data from periods in which stock dividends were considerably higher than they are today. It seems doubtful that historical SWRs could be supported with today's dividend yields, since the rate of principal depletion would be significantly higher.
I think that's an excellent point. Historically, it was very expensive to trade. It was much better for investors for a company to pay in the form of dividends than allow the stock price to appreciate. The higher taxation of dividends vs capital gains seems to reflect this (exploiting the effective selling spread caused by the high trade fees). I wonder what the relative size of the stock market vs corp bond market was in the past vs today (my searches aren't it up). What I'm getting at it is for the same risk/return, it may be necessary to hold more corp bonds and less stock. Most studies bizarrely do not account for trading costs, let alone how they affect the market shape.

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Re: Should retirement portfolios tilt toward dividend stocks

Post by Ketawa » Thu Aug 29, 2013 11:22 am

Browser wrote:Another consideration to bear in mind is that holding dividend stocks will allow the individual to sell fewer equity shares in order to support his income withdrawals, since more of his income needs can be funded from dividends. This would be especially important during bear markets, since the individual would be forced to liquidate fewer shares at depressed prices.

This factor has been overlooked in examining the results of historical SWR studies, which are largely based on data from periods in which stock dividends were considerably higher than they are today. It seems doubtful that historical SWRs could be supported with today's dividend yields, since the rate of principal depletion would be significantly higher.
I can't for the life of me understand why this belief is so persistent.

First, the specific number of shares you hold means nothing. As soon as a dividend is paid, the value of the share goes down. Does it matter if you hold 100 shares worth $9 each or 90 shares worth $10 each? Create your own dividend and pay less in taxes.

Secondly, Bogleheads are not selling equities in a bear market. They are selling bonds in order to rebalance their portfolios.

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Re: Should retirement portfolios tilt toward dividend stocks

Post by nisiprius » Thu Aug 29, 2013 11:39 am

Despite the criticisms of the dividend stock strategy, there may be another reason to consider dividend stocks in a retirement decumulation portfolio -- lower estimation risk. It may be that there is less uncertainty in estimating the volatility and returns of high dividend stocks than for the broad equity market. First, since dividends provide a relatively non-volatile floor for total equity returns, this implies there should be relatively less uncertainty about their future returns. Additionally, it also seems to be the case that the earnings of higher dividend-paying companies are more stable than for stocks in general, as discussed in this article, and this also implies lower estimation risk.
Yes, it sounds good, but look at some growth charts and tell me whether dividend stock mutual funds are that much more predictable than the stock market as a whole. I'm going to use Vanguard Equity-Income as my example, but if you think it's inappropriate, please name a more appropriate one. I'm going to compare it to 500 Index because this fund is actually older than Total Stock Market.



Vanguard says: "This fund is designed to provide investors with an above-average level of current income while offering exposure to the stock market." Blue, the high-dividend Equity-Income fund. Orange, 500 Index (S&P 500). For comparison, green, Total Bond.



Image



Do you seriously think there's any important difference in "estimation risk" between these two funds, or that it would make much change in the safe withdrawal rate of a portfolio if you swapped out Total Stock for Vanguard Equity Income?



Stocks are stocks. Bonds are bonds. Stocks are not bonds. Stocks are risky. It is bonds that have "low estimation risk," not some kind or another of stocks.



A hundred articles about various stock strategies, particularly dividend stocks, go around hand-waving and using rhetoric, not numbers, to suggest "less risk," but if you look at growth charts, what you see is that stocks are stocks and the differences are small. It's less risky the way drinking Schlitz (4.7% alcohol) is less risky than drinking Budweiser (5.0%).
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Re: Should retirement portfolios tilt toward dividend stocks

Post by bertilak » Thu Aug 29, 2013 11:43 am

Ketawa wrote:
Browser wrote:Another consideration to bear in mind is that holding dividend stocks will allow the individual to sell fewer equity shares in order to support his income withdrawals, since more of his income needs can be funded from dividends. This would be especially important during bear markets, since the individual would be forced to liquidate fewer shares at depressed prices.

This factor has been overlooked in examining the results of historical SWR studies, which are largely based on data from periods in which stock dividends were considerably higher than they are today. It seems doubtful that historical SWRs could be supported with today's dividend yields, since the rate of principal depletion would be significantly higher.
I can't for the life of me understand why this belief is so persistent.

First, the specific number of shares you hold means nothing. As soon as a dividend is paid, the value of the share goes down. Does it matter if you hold 100 shares worth $9 each or 90 shares worth $10 each? Create your own dividend and pay less in taxes.

Secondly, Bogleheads are not selling equities in a bear market. They are selling bonds in order to rebalance their portfolios.
Two points:
  1. The number of shares sold DOES make a difference since future dividends will be paid per share, not based on the total value of those shares.
  2. Those who are not adding new money (i.e. retirees) may need to sell equities to get enough income, bear market or not. The fewer dividend dollars, the more equity (shares) they will need to sell.
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Re: Should retirement portfolios tilt toward dividend stocks

Post by Wagnerjb » Thu Aug 29, 2013 12:09 pm

bertilak wrote:
Ketawa wrote:
Browser wrote:Another consideration to bear in mind is that holding dividend stocks will allow the individual to sell fewer equity shares in order to support his income withdrawals, since more of his income needs can be funded from dividends. This would be especially important during bear markets, since the individual would be forced to liquidate fewer shares at depressed prices.

This factor has been overlooked in examining the results of historical SWR studies, which are largely based on data from periods in which stock dividends were considerably higher than they are today. It seems doubtful that historical SWRs could be supported with today's dividend yields, since the rate of principal depletion would be significantly higher.
I can't for the life of me understand why this belief is so persistent.

First, the specific number of shares you hold means nothing. As soon as a dividend is paid, the value of the share goes down. Does it matter if you hold 100 shares worth $9 each or 90 shares worth $10 each? Create your own dividend and pay less in taxes.

Secondly, Bogleheads are not selling equities in a bear market. They are selling bonds in order to rebalance their portfolios.
Two points:
  1. The number of shares sold DOES make a difference since future dividends will be paid per share, not based on the total value of those shares.
  2. Those who are not adding new money (i.e. retirees) may need to sell equities to get enough income, bear market or not. The fewer dividend dollars, the more equity (shares) they will need to sell.
I agree with Ketawa's comments.

For a retiree with (for example) a 50/50 portfolio, a down market will mean he is selling fixed income to supplement the natural interest and dividends from his portfolio. If the down market is steep enough, he may need to sell additional fixed income and buy equities to maintain his target allocation. Selling equities in a down market is the very last thing that a rational retiree would do.

Best wishes.
Andy

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Re: Should retirement portfolios tilt toward dividend stocks

Post by Jack » Thu Aug 29, 2013 12:41 pm

bertilak wrote: Two points:
  1. The number of shares sold DOES make a difference since future dividends will be paid per share, not based on the total value of those shares.
  2. Those who are not adding new money (i.e. retirees) may need to sell equities to get enough income, bear market or not. The fewer dividend dollars, the more equity (shares) they will need to sell.
1. No, the two cases are mathematically identical. Ceteris paribus, the company not paying dividends will increase in price over time by exactly the same amount that the other company pays a dividend. You still have the same total return even if you sell shares of the non-dividend company. All the non-dividend company is doing is holding your dividend for you and increasing its value by the same amount. You can reclaim exactly that same amount by selling shares. Future total returns for both companies are the same, but the non-dividend company is more tax efficient.

2. Most retirees would have at least half of their portfolio in bonds. They should not be forced to sell equities in a down market. To the contrary, they should be forced to sell bonds in order to re-balance their portfolio to their target allocation. In a down market, bonds are (somewhat) likely to increase in price so they would be selling high.

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Re: Should retirement portfolios tilt toward dividend stocks

Post by Sidney » Thu Aug 29, 2013 12:46 pm

Jack wrote:2. Most retirees would have at least half of their portfolio in bonds. They should not be forced to sell equities in a down market. To the contrary, they should be forced to sell bonds in order to re-balance their portfolio to their target allocation. In a down market, bonds are (somewhat) likely to increase in price so they would be selling high.
I agree. I have never understood this "forced to sell equity in a down market." If that were true, they are too heavy in equity IMO.

I also agree with your other point but that one has been flogged to death many times over.
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Re: Should retirement portfolios tilt toward dividend stocks

Post by technovelist » Thu Aug 29, 2013 12:47 pm

Jack wrote:
bertilak wrote: Two points:
  1. The number of shares sold DOES make a difference since future dividends will be paid per share, not based on the total value of those shares.
  2. Those who are not adding new money (i.e. retirees) may need to sell equities to get enough income, bear market or not. The fewer dividend dollars, the more equity (shares) they will need to sell.
1. No, the two cases are mathematically identical. Ceteris paribus, the company not paying dividends will increase in price over time by exactly the same amount that the other company pays a dividend. You still have the same total return even if you sell shares of the non-dividend company. All the non-dividend company is doing is holding your dividend for you and increasing its value by the same amount. You can reclaim exactly that same amount by selling shares. Future total returns for both companies are the same, but the non-dividend company is more tax efficient.

2. Most retirees would have at least half of their portfolio in bonds. They should not be forced to sell equities in a down market. To the contrary, they should be forced to sell bonds in order to re-balance their portfolio to their target allocation. In a down market, bonds are (somewhat) likely to increase in price so they would be selling high.
Dividends, once paid, are irrevocably the property of the shareholder. This is not true of increases in share price. Thus, there is more shareholder risk in a "100% retained earnings" approach.
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Re: Should retirement portfolios tilt toward dividend stocks

Post by Sidney » Thu Aug 29, 2013 12:55 pm

technovelist wrote:Dividends, once paid, are irrevocably the property of the shareholder. This is not true of increases in share price. Thus, there is more shareholder risk in a "100% retained earnings" approach.
Not if you sell. With share price appreciation, you have more flexibility. You can sell or not. With dividends, you don't get a choice ... the company is selling for you.
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Re: Should retirement portfolios tilt toward dividend stocks

Post by Jack » Thu Aug 29, 2013 12:57 pm

technovelist wrote:Dividends, once paid, are irrevocably the property of the shareholder. This is not true of increases in share price. Thus, there is more shareholder risk in a "100% retained earnings" approach.
You can collect that dividend any time you like by selling the appropriate equivalent in shares, not at the whim of a dividend paying company. Collecting the dividend at a time of your choosing and at a capital gains rate is more tax efficient.

The danger is that cash flush CEOs may squander your dividend before you collect it, but that is an entirely different issue from the original question.

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Re: Should retirement portfolios tilt toward dividend stocks

Post by Beagler » Thu Aug 29, 2013 11:54 pm

A Boglehead recently wrote that he feels 'income subject to market price risk is not the foundation for a sustainable retirement strategy.'
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Re: Should retirement portfolios tilt toward dividend stocks

Post by Browser » Fri Aug 30, 2013 12:04 am

Beagler wrote:A Boglehead recently wrote that he feels 'income subject to market price risk is not the foundation for a sustainable retirement strategy.'
Or another way of putting it is that it is difficult to match known liabilities with assets that produce volatile returns.
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Re: Should retirement portfolios tilt toward dividend stocks

Post by convert949 » Fri Aug 30, 2013 9:23 am

"
Browser wrote: This topic is examined in some detail in this paper from Geoff Considine. He refers to the strategy of investing in the broad stock market as the total-return strategy, and the strategy of investing in dividend stocks as the income-oriented strategy. He summarizes his conclusions as follows:
1. Total-return-oriented portfolios have higher expected return and higher estimation
error than income-oriented portfolios.

2. The SWRs for total-return strategies are higher than for income strategies, but they
are more likely to require revisions and adjustments due to changes in the projected
equity risk premium.

3. Income-oriented strategies will provide lower SWRs but with a lower probability of
downward adjustments to the withdrawal rate, because they are less likely to
require substantial selling into a declining market (one of the worst scenarios for
retirees).

4. Portfolios designed to optimize total return but with a threshold income level that
must be satisfied (as in my third scenario above) are a compromise solution.
http://advisorperspectives.com/newslett ... _Rates.php
Funny... Using Geoff Considine's own Quantext Monty Carlo simulator, I evaluated the effect of selling Total Stock Market vs. selling Vanguard Dividend Growth as I re-balanced my portfolio recently. Selling Dividend Growth instead of Total Stock Market resulted in being able to achieve the same portfolio return with 2% less equity, lower volatility and a higher diversification metric.

Therefore, one could assume that the Total Return method has the lower risk when equity percentage is adjusted downward to match the somewhat lower return of the dividend approach... If fact, in this scenario, you have an additional 2% bonds to enhance your bond cushion helping to avoid selling equities in a bad market :)

Regards to all,

Bob

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Re: Should retirement portfolios tilt toward dividend stocks

Post by nedsaid » Fri Aug 30, 2013 10:32 pm

I love dividends and I love dividend paying stocks. At this time, I would not tilt a portfolio towards dividend stocks. The reason is valuations. Larry Swedroe started a great thread on this. RIght now, the S&P Dividend ETF (SDY) shows a P/E of 18 and a dividend yield of 2.61%. The S&P 500 ETF (SPY) shows a P/E of 15 and a dividend yield of 1.98%. (Source: Yahoo Finance).

My expectation is that higher dividend stocks normally have good value characteristics. I am a value oriented investor. Normally, I would expect higher dividend stocks to have lower P/E's than the S&P 500. Instead, the dividend ETF has a higher P/E than the market itself. One could say that these high dividend payers are riskier than the market itself at these prices!!

The above numbers from Yahoo Finance show me that investors chasing yields have bid higher dividend stocks up to the point to where they do not represent value. When bond yields go up, I would expect the price of these stocks to go down along with bonds. At whatever point investors figure out you can get a better yield in bonds than in these stocks at much less risk, the returns on these stocks will be subdued to say the least. The yield chasers will go back to bonds.

So it is not a bad idea to tilt retirement portfolios toward dividend stocks. What I am suggesting is that now is not a good time to execute this strategy.
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Re: Should retirement portfolios tilt toward dividend stocks

Post by statsguy » Sat Aug 31, 2013 7:31 am

nisiprius wrote: Vanguard says: "This fund is designed to provide investors with an above-average level of current income while offering exposure to the stock market." Blue, the high-dividend Equity-Income fund. Orange, 500 Index (S&P 500). For comparison, green, Total Bond.



Image

Not that it affects your argument very much, but wasn't Vanguard Equity Income a Utility fund until about 2000? I do not follow this fund (though do allocate 25% of our portfolio to dividend stocks) but remember many being upset when it switched from pure utility fund to its current form.



Stats

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Re: Should retirement portfolios tilt toward dividend stocks

Post by YDNAL » Sat Aug 31, 2013 7:59 am

nedsaid wrote:I love dividends and I love dividend paying stocks. At this time, I would not tilt a portfolio towards dividend stocks. The reason is valuations. Larry Swedroe started a great thread on this. RIght now, the S&P Dividend ETF (SDY) shows a P/E of 18 and a dividend yield of 2.61%. The S&P 500 ETF (SPY) shows a P/E of 15 and a dividend yield of 1.98%. (Source: Yahoo Finance).
SDY is a very narrow (83 holdings) fund/ETF, SEC 2.36%, where 2 of 5 top holdings are REITs (and 3 of 20).
http://etfs.morningstar.com/quote?t=SDY

Conversely, Vanguard High Dividend Yield ETF (VYM, Fund: VHDYX, 388 holdings) shows P/E of 15.9 and SEC 2.96%.
https://personal.vanguard.com/us/funds/ ... =INT#tab=2
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Re: Should retirement portfolios tilt toward dividend stocks

Post by IlikeJackB » Sat Aug 31, 2013 8:07 am

statsguy wrote:
Not that it affects your argument very much, but wasn't Vanguard Equity Income a Utility fund until about 2000? I do not follow this fund (though do allocate 25% of our portfolio to dividend stocks) but remember many being upset when it switched from pure utility fund to its current form.

Stats
Again not that it matters much, but it's the Dividend Growth fund you're thinking of, Stats.
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Re: Should retirement portfolios tilt toward dividend stocks

Post by YDNAL » Sat Aug 31, 2013 8:16 am

IlikeJackB wrote:
statsguy wrote:Not that it affects your argument very much, but wasn't Vanguard Equity Income a Utility fund until about 2000? I do not follow this fund (though do allocate 25% of our portfolio to dividend stocks) but remember many being upset when it switched from pure utility fund to its current form.

Stats
Again not that it matters much, but it's the Dividend Growth fund you're thinking of, Stats.
Vanguard Equity Income, as actively-managed funds go, hired Wellington to replace Spare, Kaplan, Bischel in 2000 to add more focus on stocks with reasonable yields and the possibility of growing dividends.
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Re: Should retirement portfolios tilt toward dividend stocks

Post by nisiprius » Sat Aug 31, 2013 9:32 am

As I said,
I'm going to use Vanguard Equity-Income as my example, but if you think it's inappropriate, please name a more appropriate one.
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Re: Should retirement portfolios tilt toward dividend stocks

Post by nedsaid » Sat Aug 31, 2013 10:02 am

Thanks YDNAL for your post. The Vanguard High Dividend Yield ETF looks a whole lot better than the S&P Dividend ETF. Still the P/E is higher than the S&P 500 and shows that these stocks have been bid up. I suspect the REITs in the S&P Dividend ETF have pushed up the P/E ratios. So if I had to choose between the two, I would certainly buy the Vanguard product.

I still would advise investors not to chase dividend yield at this point. Prices are certainly better than a month ago, but if one is willing to wait I suspect that even better prices are ahead. Again, my expectations for these kind of stocks would be that they would exhibit good value characteristics. Even the Vanguard ETF has higher P/E than the market as a whole.

I was a dividend and value investor before it was cool. I don't think this is a great time to buy these. Larry Swedroe has a couple of good threads on this topic and I have to agree with him. Valuations matter.

So if you have lust in your heart for the high dividend stocks, you would be better off with the Vanguard High Dividend ETF than the S&P Dividend ETF.
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