This post is the third in a series exploring the myths and misunderstandings about dividend investing. The goal of the series is to argue that many investors following a dividend-focused strategy may be better off with broad-based index funds.

Dividend Myth #3: Dividend-paying stocks are a substitute for bonds in an income-oriented portfolio.

It’s awfully hard to get excited about fixed-income investments these days. During most periods in the past, bonds and GICs paid interest rates significantly higher than the average stock dividend. But not today: five-year GICs are now pulling down about 3%, while 10-year federal bonds are earning less than 3.5%. The dividend yield of the S&P/TSX Composite Index is about a point lower than that, but it’s easy enough to build a stock portfolio that pays 4% or more.

No wonder I frequently hear from investors who have ditched fixed-income investments altogether in favour of dividend-paying stocks. Indeed, some popular dividend gurus advocate throwing fixed income to the dogs altogether, no matter what market conditions happen to be. “I don’t understand why people switch to bonds in retirement,” writes Tom Connolly of the popular Dividend Growth website. “Have you ever known a bond to increase its interest rate?” Lowell Miller, author of The Single Best Investment: Creating Wealth with Dividend Growth, opens his book with a whole chapter devoted to bond bashing: “Let me put it bluntly: bonds are a bad investment.”

Both of these authors argue that stocks with a track record of growing dividends can provide an income that rises every year, even if the stocks themselves fall in value. Bonds, meanwhile, pay a fixed coupon until their maturity date. “In 2008, our dividend income rose in spite of the turmoil by 9.9%,” Connolly wrote in 2009. “Did your income rise by 10% last year?”

It’s true that dividend-growth stocks can provide a steadily rising income for investors in retirement. But any investor contemplating an all-equity portfolio should make absolutely certain they understand what they’re doing.

Dividend stocks are not “bonds with growth”

Connolly scoffs that bonds do not raise their interest rates, but that’s never been the reason for including them in a portfolio. Investors buy bonds because the interest income is guaranteed. (Unless the issuer goes bankrupt, of course, but this is a negligible risk with government bonds, and an extremely small one with investment-grade corporate bonds.) One might ask Connolly, “Have you ever known a stock to reduce its dividend?” Of course, this happens frequently, even with blue chip companies. Remember, a company is not legally bound to pay dividends, but it must never reduce the coupon on its bonds.

The other consideration is the risk of capital loss. Bonds fall in value when interest rates rise, but stocks can suffer declines that are far more gut-wrenching. A portfolio of dividend-paying stocks might well have seen its income go up by 10% in 2008, but it likely lost 30% to 40% of its overall value before the market bottomed.

Consider that in dollar terms: imagine a retired investor with a $1-million portfolio generating $40,000 a year in dividends in 2008. Assume (generously) that every company she owns raised its dividend by 10% that year, bumping up her income by $4,000. Meanwhile, the portfolio’s value would have dropped by as much as $400,000. If you can stomach a loss like that in retirement, then an all-stock portfolio is perfectly appropriate for you. But few people can. Derek Foster couldn’t do it, and he was under 40 when he sold everything in a panic. Ask any financial advisor how clients in their 60s and 70s handled the crash of 2008–09, and how much solace they took in the fact that most of their stocks continued to pay dividends.

A more balanced approach

There is an alternative for investors who want rising income in retirement. It’s based on the highly influential research of William Bengen, first published in 1994 and updated many times since then. Bengen determined that investors with a portfolio of 50% stocks and 50% bonds can safely withdraw 4% in the first year, followed by inflation-adjusted withdrawals each succeeding year. For example, our investor with $1 million can take out $40,000 in year one. If inflation is at 3%, she can raise her withdrawal to $41,200 in year two, and $42,436 in year three.

Bengen ran his simulations using decades of historical returns and inflation scenarios, and found he that a portfolio drawn down using this “4% rule” has an extremely high likelihood lasting throughout retirement. Upping the stock portion to 75% allowed retirees to raise their withdrawal rate even further, so long as they could accept the additional risk. Bengen’s research revolutionized retirement planning and is widely followed by financial professionals.

The point is that it’s not necessary to rely solely on dividend-paying stocks to provide a cash flow that keeps pace with inflation. Keeping 25% to 50% of a portfolio in bonds will dramatically reduce a portfolio’s volatility and still provide retirees with the rising income they desire.

Other posts in this series:

Dividend Myth #1: Companies that pay dividends are inherently better investments than those that don’t.

Dividend Myth #2: Dividend investors are successful because they select excellent companies and buy them when they are attractively priced.

Dividend Myth #4: You can beat the market with common sense: just focus on blue-chip companies with a competitive advantage and a history of paying dividends.

Dividend Myth #5: It’s easy to build a well diversified portfolio of Canadian dividend stocks.

Dividend Myth #6: Investors who follow a dividend growth strategy will eventually beat the market on yield alone.