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Donít Confuse Stocks with Bonds

November 28th, 2007 at 05:10 pm

In the November 28th Wall Street Journal, Jonathan Clements seems to suggest that investors increase their yield on the fixed asset (bond and bond funds) portion of their portfolio by buying stocks (especially banking stocks) with a high dividend yield.

What his column seems to ignore is that a significant reason to buy fixed assets is to provide diversification and protection for when the stock market tanks. High yield stocks have a high yield because the company can find nothing better to do with their income than to redistribute it to their shareholders. Stock holdings in these companies can often be a high risk investment.

Often, high yields occur when a stock price falls precipitously. Consider Washington Mutual (WM) which currently yields around 13%. This stock has fallen approximately 60% since June, when itís 5% yield was considered high. In WaMuís present financial condition, the odds are very high that the dividend will receive a substantial cut in the near future.

The reason to diversify into fixed assets is not for your fixed income investment to outperform the equity market. You diversify to lower your overall investment risk. Short term bonds, CDs and money market funds will hold most, if not all of their value when the stock market sinks. High yielding stocks will fall with a falling market, often at an even faster rate than the overall market.

If you choose to chase high yields, be sure that you do not confuse stocks with bonds. Keep your high yielding stocks on the stock side of your portfolio. They are NOT fixed assets that will hold their value when the market declines.

4 Responses to “Donít Confuse Stocks with Bonds”

  1. Broken Arrow Says:

    Thank you for sharing this, because it's a very good point. It also relates to something that's highly discussed in the forums right now. Were you reading that when you got the idea for this entry? Smile
    I definitely agree the need to differentiate between stocks and bonds, low risk versus high risk, as well as diversification.

    I would say, however, that bonds are not the only way to diversify. Some do prefer commodities such as precious metal or real estate. Others who are much more aggressive have gone with energy.

    As for dividend bonds, I agree it's important to know the quality of such stocks. When I hear dividend stocks, my first question is always, "Why?" Why are they paying dividends? Is it because they're growth has stabilized, or is it because the company is somehow poorly managed and losing value? Especially with high interest stocks, some are actually quite volatile as they risk having the dividend cut, or perhaps even being delisted.

    But the message is to keep these things separate, and that I certainly agree with.

  2. Broken Arrow Says:

    Oops! I meant dividend stocks in the 4th paragraph.

  3. finabguide Says:

    You are exactly right when you say that there are many ways to diversify and I did not mean to imply that bonds or other fixed income investments are the only means of diversification for stocks. As a matter of fact, I believe that the weakening dollar and the possibility of increasing inflation bode well for a small gold position at this point.

    My only point was, in reference to the WSJ column, high dividend stocks are not bonds and do not provide the same type of diversification protection as bonds. Anyone who read that column might be mislead into believing that they could use high yield stocks,instead of bonds and have the same diversification protection.

  4. Amber Says:

    thanks for the post, I am still learning and this is great

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