Published on April 10th, 2017 by Nicholas McCullum
The goal of any investor should be either:
- Maximize returns given a fixed level of risk
- Minimize risk given a fixed level of desired returns
Incorporating both returns and risk into an investment strategy can be tricky. Performance is easy to measure, but risk can be more difficult to quantify.
After all, how do we define risk? Is it the probability of losing money (which itself is hard to estimate), or something else?
The investment community has generally accepted volatility as the best proxy for investment risk. Volatility is a stock’s tendency to ‘bounce around’. Low volatility dividend stocks will produce consistent returns, while high volatility stocks tend to be more unpredictable.
Fortunately for dividend investors, dividend stocks have great risk-adjusted returns when compared to even the safest asset class – government bonds.
Click here to download an Excel Document that compares the risk-adjusted performance of dividend stocks to long-term government bonds.
Conservative investors can juice a bit more yield out of government bonds by venturing further out on the yield curve and investing solely in 20- or 30-year government bonds, which collectively are called ‘long-term’ government bonds.
With the added returns from investing in longer-term bonds, many would assume that long-term government bonds and dividend stocks would have a similar risk/reward profile.
This article will compare the risk-adjusted returns of dividend stocks and long-term bonds in detail. The article will conclude by detailing a few actionable ways that investors can improve the risk-adjusted returns of their portfolio.
Measuring Risk-Adjusted Returns
The most common metric to measure risk-adjusted returns is the Sharpe Ratio.
The Sharpe Ratio measures how much additional return is generated for each unit of risk. It is calculated as:
One of the tricky elements about performing a Sharpe Ratio analysis is determining what to use for the risk-free rate of return. When analyzing stocks, the 10-year U.S. government bond yield is often used, as the probability of a default from the U.S. government is generally assumed to be zero.
However, this article will be analyzing both stocks and bonds, so using a 10-year bond yield as the risk-free rate would be inappropriate. Accordingly, the yield on the 3-month U.S. Treasury Bill (t-bill) will be used as the risk-free rate of return throughout this article.
The long-term trend for the yield of 3-month t-bills can be seen below.
The 3-month t-bill yield has remained close to zero since the financial crisis, but has increased recently in the new rising interest rate environment.
Next, I must identify appropriate benchmarks for the aggregate long-term bond market and the universe of dividend stocks.
As a proxy for the aggregate long-term bond market, this analysis will be using the iShares 20+ Year Treasury Bond ETF (TLT). This ETF has approximately $6 billion in assets under management and is benchmarked to the ICE U.S. Treasury 20+ Year Bond Index.
As a proxy for dividend stocks, this analysis will use the iShares Select Dividend ETF (DVY). This ETF has approximately $17 billion of assets under management and is benchmarked to the Dow Jones U.S. Select Dividend Index.
Normally, I would prefer to use an ETF that tracks the performance of the Dividend Aristocrats, which is our favorite universe for identifying high-quality dividend stocks. To be a Dividend Aristocrat, a company must raise its dividend payments for at least 25 consecutive years.
Unfortunately, the ETF which best tracks the performance of the Dividend Aristocrats index is the ProShare S&P 500 Dividend Aristocrats ETF (NOBL). This ETF has only been trading since 2013 and thus is not a good proxy for long-term investment returns. DVY has been trading since 2003 and has a much longer track record for which to make comparisons. As such, DVY will be used to represent dividend stocks during this analysis.
Dividend Stocks vs. Long-Term Bonds: Comparing Risk-Adjusted Returns
The trailing 1-year Sharpe ratio for dividend stocks and long-term government bonds can be seen below.
Admittedly, the above graph is a bit noisy and is hard to draw a conclusion from. While it appears that dividend stocks tend to have a higher Sharpe ratio than long-term government bonds during most time periods, there are notable stretches (including the 2007-2009 period encompassing the financial crisis) where this trend does not hold true.
On average, though, dividend stocks have outperformed long-term government bonds on a risk-adjusted basis over all meaningful time periods. This trend is better illustrated below.
This data debunks the belief that long-term government bonds and dividend stocks have similar risk/reward profiles. Given that dividend stocks have better absolute returns as well as better risk-adjusted returns, this supports our belief that dividend growth investing is one of the best ways to compound wealth.
Improving Risk-Adjusted Returns
Looking back to the formula for the Sharpe Ratio, there are mathematically three ways to improve this metric:
- Improve investment performance
- Reduce the risk-free rate of return
- Reduce portfolio volatility
While this is true mathematically, investors actually have no control over the risk-free rate of return. Accordingly, this section will focus on increasing investment performance and reducing portfolio volatility.
Many investors mistakenly believe that they have no control over the performance of their investments and resort to ETF investing to match the market’s average return. However, there are many trends that investors can take advantage of to increase portfolio returns.
For example, stocks with steadily rising dividends tend to outperform the market. Companies that are able to increase their annual dividend payments for multiple years clearly have some sort of defensible competitive advantage which allows them to remain highly profitable through various market cycles. Accordingly, we view a strong dividend history as a screener for a high-quality business.
This trend is best seen by looking at the Dividend Aristocrats. The outperformance of the Dividend Aristocrats over the past decade can be seen below.
If the Dividend Aristocrats are not of high enough quality for an investor, they could also consider investing in the Dividend Kings. To be a Dividend King, a company must have 50+ years of consecutive dividend increases – twice the requirement to be a Dividend Aristocrat.
For a more broad universe of stocks, the Dividend Achievers contains 265 stocks with 10+ years of consecutive dividend increases.
Investors can also boost returns by investing in stocks that are cheap compared to both the rest of the market and the stock’s historical average. The typical metric that is used to measure valuation is the price-to-earnings ratio, but dividend yields also are indicative of a company’s current valuation.
If a stock is trading above its long-term average dividend yield, its valuation is more attractive. This is why the Sure Dividend Newsletter ranks stocks by dividend yield according to The 8 Rules of Dividend Investing.
Finally, investors can also boost risk-adjusted returns by reducing portfolio volatility. The easiest way to reduce portfolio volatility is to smartly diversify across industries and sectors. Mathematically, the best way to reduce portfolio volatility is by investing in pairs of stocks that have the lowest correlation, such as Medtronic (MDT) and McDonald’s Corporation (MCD) – which form the pair of Dividend Aristocrats with the lowest correlation.
Portfolio volatility can also be decreased by investing in companies with low stock price volatility. Stocks with strong total return potential but low stock price volatility include Johnson & Johnson (JNJ), Hormel Foods (HRL), The Coca-Cola Company (KO), and Abbott Laboratories (MCD).
Dividend growth investing is an attractive investment strategy on both an absolute basis and a risk-adjusted basis. The following articles will help the beginner investor get started building their dividend growth portfolio: