Aaaahhhh the good old topic of asset allocation. As a financial planner, I work continually with my clients to optimize their asset allocation so they maximize their return and minimize their risk. Investing is good, diversifying is great, but optimizing your investments through a solid asset allocation and diversification with the right solutions is the best. However, it has become a bit harder to determine your asset allocation when it comes to dividends – where do you include them in your asset allocation?
Classic Asset Allocation Model
If you take a classic asset allocation model, you will have 2 types of assets (I know, this is very basic):
Asset class A: Fixed income
Asset class B: Equities
Fixed income is pretty easy to define when you look at bonds and certificates of deposit: they all pay a steady interest income.
If you look at Equities, you get a simple definition as well: they are shares issued by public companies.
So where do you put a share of a public company paying steady dividends?
Dividend stocks are sitting comfortably on the line between fixed income (since they are paying a steady income) and equities (as shares will benefit from capital growth).
Therefore, one can easily say that he picks “secure” dividend payers (such as dividend aristocrats or dividend achievers) and puts his dividend holdings into the fixed income portion. On the other hand, someone else could say that he manages a portfolio of stocks, that are paying dividends as a bonus) and puts his holdings in the equity section. But do they know the volatility and risk factors attached to their portfolio?
Where the line becomes even more gray
It’s even worse when you look at mutual funds. Since most dividend funds also include a bonds in their portfolio, they can be included in fixed income. However, I’m sure that you will agree with me that if someone is looking for a highly secure portfolio (90%+ in fixed income), dividend funds might not be the right solution for him. I’m not sure that retirees should blindly follow their financial advisors and invest massively into dividend funds without knowing the difference in fluctuation between a bond fund and a dividend fund.
I know, the bond fund can also lose value if interest rates climb suddenly. However, I don’t think bond funds in general will fluctuate as much as dividend funds.
Dividend stocks should be considered as a balanced investment
Because of their double nature, I would be tempted to say that my dividend holdings represent an investment at 50% in fixed income and 50% in equities. Dividend paying stocks are usually less volatile than non dividend paying stocks and they generate a steady cash flow for the shareholder. On the other hand, shares will also appreciate upon good news on the market. This is why I think it should be considered as a balanced investment.
In fact, if you want to have a “safer” or a “more aggressive” dividend portfolio, you can manage your asset allocation per investing sector:
For example, if you concentrate more on utilities, you should have a “safer” portfolio as several utility companies are paying about the same dividend payout ratio and are very stable in their payments. Whereas consumer cyclicals can experience a lot more growth during an economic recovery.
As for me, I am not buying bonds right now because I think dividend stocks are better than bonds. Therefore, I would rather have a “balanced” portfolio with dividend stocks than have 50% of my investments in bonds paying low interest ;-). I have also preferred to add a little bit more growth in my portfolio with 4 stocks in the energy sector (VNP and PDN don’t pay dividends though) while keeping my shares of RIM at the moment. Hopefully the Playbook will put back RIM on the map so I can sell my shares with a good profit by the end of the year ;-).