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Smooth the Stock Market Roller Coaster

| MoneyRates.com Senior Financial Analyst, CFA
min read

stock-market-volatilityIncome generation is not a very sexy investment topic. Investment talk shows and websites are much more interested to spot the next Apple than they are with portfolio income yield; but when it comes to retirement investments, portfolio income plays a dual role: it can provide liquidity for living expenses while also acting as an important source of portfolio stability.

The value of portfolio income generation for stability

Every investor who owns stocks should recognize that they can go up or down in price and, at times, the roller coaster can be quite dizzying. However, if you focus on income generation, you may find the ride much smoother.

To illustrate this, consider the two great bear markets of the 21st century (so far, anyway). One accompanied the global financial crisis and spanned from September 30, 2007 through the first quarter of 2009. The other was marked by the collapse of dot-com stocks and spanned from March 31, 2000 through September 30, 2002.

In the case of the dot-com collapse, the price level of the S&P 500 fell by 45.6 percent from high point to low point. For investors in general and retirees in particular, having the value of your investments fall by almost half could be disastrous, but there was a silver lining. At its worst, annual dividend production of the S&P 500 dropped by just 6.4 percent during this bear market.

So, while prices experienced a severe setback, investors concerned primarily with the income generation of their portfolios felt a much milder impact. As this shows, portfolio income can be a huge stabilizing factor - especially for retiree portfolios meant to provide income during retirement but which don't have as long to wait for prices to recover.

The bear market that accompanied the financial crisis was even harsher; but, still, portfolio income provided some measure of stability. In this case, the S&P 500 dropped by 47.7 percent. At its worst, 12-month dividend generation of the S&P 500 dropped by 24.1 percent. That was worse than in the prior bear market, but yet only about half the decline in prices.

Here's an interesting connection between those bear markets that underscores the steadying impact that income generation can have. The 2007-2009 bear market was so severe that the low point for the S&P 500 was actually beneath the low point of the previous bear market about seven years earlier. However, even at its low point, S&P 500 dividend production in that later bear market remained nearly 40 percent higher than at the low point of the previous bear market.

In short, an investor focused on income generation would have had a relatively smooth ride through the roller coaster of these two bear markets.

The bond price and yield trade-off

While bonds are generally considered safer than stocks, even their prices are subject to some jarring ups and downs. Here too, though, income generation provides some measure of stability.

The mechanism of bonds is that, as their prices fall, their income yields generally rise and vice versa. So during bear markets for bonds, investors at least have the partial consolation of rising income yields. For retirees dependent on that income, that should be a key source of comfort even as prices fall, especially for high-quality bonds with low default risk.

Unlike most bonds which have fixed interest payments, stock dividends are not set in stone. Companies are free to raise and lower them depending on conditions - though they try to keep them somewhat stable. As noted previously, dividends on stocks did not decline nearly as much as prices during the last two bear markets; so to some extent, the dynamic of dividend yields behaved similarly to the dynamic of bond yields - as prices fell, dividend yields rose.

This dynamic is especially important today, as stocks may be playing a particularly significant income-generation role in many portfolios. The current dividend yield on the S&P 500 is 1.94 percent, not far off from the 30-year average of 2.10 percent. However, 10-year Treasury bonds today are yielding about 2.6 percent, a far cry from their 30-year average of 4.7 percent.

With bonds providing less income than usual, the income-generation ability of stocks becomes more important. While this may lead investors to a more risky stock/bond mix, the dynamics discussed in this article should take some of the edge off that risk for income-oriented investors.

So, while finding the next high-flier tends to dominate investment chatter, focusing on portfolio income is a key to creating an all-weather investment program that can serve a valuable purpose in good times while creating relative stability in the bad times.

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