Published by Nick McCullum on November 20, 2017
One of the largest questions that faces investor is what asset classes to invest in.
The two largest are stocks (equities) and bonds (fixed income).
How can an investor know which asset class to invest in, or what proportions should be used in a mixed strategy?
It all comes down to your fundamental investment goals. We believe 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 return and risk into an investment strategy can be difficult. While performance is easy to measure, 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 measurement for investment risk. Volatility is a stock’s tendency to ‘bounce around’. Low volatility dividend stocks will produce consistent returns, while high volatility stocks have more unpredictable return sequences.
With this in mind, dividend stocks have historically produced superior total returns compared to their fixed income counterparts. This is because established dividend stocks like the Dividend Aristocrats – stocks with 25+ years of consecutive dividend increases – have generated superior performance that more than offsets their higher volatility relative to bonds.
For this reason, we believe dividend stocks are a compelling investment opportunity when compared to bonds – their biggest ‘competitor’ as an investment.
This article will compare the risk-adjusted returns of dividend stocks and 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 with the following equation:
One of the tricky elements of 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 (as it will assign a Sharpe Ratio of zero to fixed-income instruments). Accordingly, the yield on the 3-month U.S. Treasury Bill will be used as the risk-free rate of return throughout this article.
For your reference, the long-term time series for 3-month Treasury Bill yields can be seen below.
As you can see, 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, we need to pick appropriate benchmarks by which to measure the performance of dividend stocks and bonds.
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. 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.
For bonds, we’ll be using the iShares Core U.S. Aggregate Bond ETF, which trades on the New York Stock Exchange under the ticker AGG and has $52 billion of assets under management. The fund is benchmarked to the Bloomberg Barclays U.S. Aggregate Bond Index.
The next section of this article compares the performance of these two asset classes in detail.
Dividend Stocks vs. Bonds: Comparing Risk-Adjusted Returns
The trailing 1-year Sharpe Ratio for dividend stocks and bonds can be seen below.
Admittedly, the graph above 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 a diversified basket of bonds during most time periods, there are notable stretches (including the 2007-2009 financial crisis) where this does not hold true.
Indeed, dividend stocks have outperformed bonds during 1-year, 3-year, and 5-year time periods. This trend is better illustrated below.
While bonds have had a higher Sharpe Ratio during the important 10-year time period, there are two reasons why we remain far more bullish on dividend stocks than on bonds:
- Dividend stocks have delivered higher absolute returns than bonds during all meaningful time periods. Sometimes, ‘risk-adjusted returns’ aren’t the most important metric if they expose you to the risk of compounding your wealth at rates that are highly inadequate. As an example, the 10-year U.S. Treasury bond yields about 2.3% while many high-quality dividend stocks have far higher dividend yields.
- We are coming to the end of a multi-decade bull market in bonds. Bond prices fall while interest rates rise, and the Federal Reserve has communicated the intent to continue raising interest rates moving forward. This means that the next several years are not likely to be kind to bond investors.
Altogether, we remain convinced that dividend growth investing is one of the best ways to compound individual wealth.
The next section of this article will describe actionable methods that investors can use to improve the risk-adjusted returns of their investment portfolios.
Improving Risk-Adjusted Returns
Looking back to the formula for the Sharpe Ratio, there are mathematically three ways to increase this metric:
- Improve investment returns
- Reduce the risk-free rate of return
- Reduce portfolio volatility
While these three factors are mathematical variables, 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 index investing (more specifically, ETF investing) to match the performance of some benchmark. This is not necessarily the case. There are many trends that investors can take advantage of to increase portfolio returns.
One example is the observation that stocks with steadily rising dividends tend to outperform the market. Companies that are able to increase their annual dividend payments for years (or even decades) clearly have some sort of defensible competitive advantage which allows them to remain highly profitable through various market cycles. Accordingly, we view a long dividend history as a sign of a high-quality business.
There is no better example of this than the aforementioned Dividend Aristocrats, who has simultaneously outperformed the broader stock market while generating less volatility – a trend which is shown below.
If the Dividend Aristocrats are not of high enough quality for an investor, they could also consider investing in the even more exclusive 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 List contains 265 stocks with 10+ years of consecutive dividend increases.
Aside from investing in high-quality businesses, 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: