Editor's Note: This is one in a series of commentaries by financial-services professionals.
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In a quest for protection from increasingly volatile markets, investors have yanked a page out of legendary value investor Benjamin Graham's tome, The Intelligent Investor, and are persistently seeking investment strategies that provide them with a safety edge.
Over the last few decades, conventional investment wisdom has taught most investors to seek the highest return from growth stocks, create diversified, yet passive (buy and hold), portfolio allocations, and ignore short-term volatility in order to reap the benefits of rising stock prices over time. In theory, this strategy can work for them. However, reality is that investors must be willing to endure potentially significant declines in the portfolio value in order to achieve their goals.
Regretfully, this strategy has miserably failed, as it is hard for the average investor to ignore volatility and declining account values. Very often, they succumb to the itch to take action and embark in a quest to shield their portfolios from the adverse impact of the falling markets. By doing so, they abandon their original plan of "buy and hold" and oftentimes end up selling low — not high — ultimately, causing a significant erosion of their capital base. High returns offered by growth stocks from price appreciation during bull market trends have become elusive to investors in recent years.
The rules of investing are undergoing a dramatic change, as investors revolt against failed strategies and become more aware of the fact that dividend-paying stocks, not growth stocks, should become the foundation on which portfolios are built.
When the government lowered the tax on capital gains for the first time in 1981, a new tax-driven preference for owning growth stocks caused many investors to forget about dividends and the benefits that they provide. In a rush to pay lower taxes, safe and consistent quarterly dividend (a component of return) was abandoned in favor of pure price appreciation – the only component of growth stocks. Unfortunately for investors, prices fell fast and hard, as the remarkable bull market of the '80s and '90s became a distant memory.
Back in the Spotlight
The good news for advisors is that dividend-paying stocks are back in the spotlight. In 2003, the government passed new tax legislation removing the arbitrary tax preference for returns generated by capital gains and provided tax relief to returns from dividends. This prompted a significant number of investors to revert to increasing their allocations to dividend-paying strategies.
One of the big selling points for dividend paying stocks is that they often provide a safe harbor during uncertain times. Investors can count on the steady and reliable return from dividends. In addition, dividend payers tend to be less volatile; which provides a major appeal, as huge market drops or extended periods of volatility are hard to stomach for the average investor. During the 2000-2002 bear market, the dividend-focused Dow Jones Industrial Average Index fell 26%, while the growth stock oriented NASDAQ Composite Index fell 67%.
