The risk of high dividends

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NEW YORK (Money) -- Question: I just turned 60. My husband and I had about $40,000 in our 401(k) invested in the market and just lost half of it. We live in a very depressed part of the country - Michigan - no work. So we were invested in "aggressive income" stocks - big mistake, but we needed the dividends to live on. This is all the money we have, so do we reinvest or what?

The Mole's Answer: The belief that stocks with high dividends are better than the market as a whole is, unfortunately, an all too common misconception.

Case-in-point: I once had an investor come to me with a portfolio earning a 14% dividend yield. The investor boasted of the "unfair advantage" he believed he had over other investors because the overall market had only returned a 2% dividend yield. I had to burst his bubble and reluctantly showed him that, when factoring in sluggish performance, he actually had lagged the market in total return by over 10% a year. And this was well before the recent market plunge.

Stocks paying the highest dividends do so for a reason. Most of the high dividend yielding stocks got that way because the price of the stock plummeted. That's the market's way of saying those dividends are risky and the possibility of a cut is significant. Which stocks were paying the highest dividends this year? As a whole, financial services firms were. And, of course, this is the sector of the stock market that has performed the worst and dragged the world into financial crisis.

Now to your question as to what you should do now. I'm sorry to be the bearer of bad news but if you have only $20,000 saved for retirement, it's very unlikely this amount will sustain you financially, though I have to say $40,000 would not have been that much better.

I don't know the specifics of your situation such as estimated social security benefits, any pensions, or how much you need to live on, but here are a couple of rules of thumb that I typically tell people:

I have been showing clients a chart derived from Jeremy Siegel's book, "Stocks For The Long-Run" (McGraw-Hill, 2002), that shows 200 years of the history of the stock market. It illustrates just how volatile stocks are in the short run. It shows that stocks have lost nearly 40% in real terms in any one year and this is likely to be the year they do even worse.

My conclusion is that any money you need in the next five to ten years is too risky to be in the stock market. Much better places to invest in the short run are secure fixed income or money market securities. I happen to be a real fan of searching for the highest paying government-insured CDs, especially now that the FDIC and NCUA insurance have been increased to $250,000 through December 2009. My favorite place to find these highest CDs is on http://bankdeals.blogspot.com/.

I adamantly advise that you avoid rolling for the extra yield by going with a bank that is not insured by the U.S. government. If you want autopilot, then buy a broad bond index fund like the Vanguard Total Bond Market Index Fund (VBMFX) that owns both U.S. agency backed bonds and investment grade bonds. It tracks the Lehman Brothers Aggregate Bond Index, which may be in search for a new name. How about the Mole Aggregate Bond Index?

For investors with cash and courage - rather rare right now - I do recommend broad U.S. and international stock index funds right now, with our 50% off sale. That's not to say I have a clue as to how the market will do in the next few years but I think the odds are great that it will be at higher levels ten years from now.

Don't chase dividends, sectors, countries or anything else. A broad U.S. fund like the Fidelity Spartan Total Market Index Fund (FSTMX) and a broad international index fund like the Vanguard Total International Stock Fund (VGTSX) could fit the bill.

I strongly recommend owning the global stock market over betting it all on individual stocks or sectors such as aggressive income stocks. Citigroup (C, Fortune 500) sure has an attractive dividend yield right now but I'm not going to bet they keep this yield. Don't bet all of your marbles on any one part of the market.

Finally, if you invest this money in the market with the intent of keeping it there for ten years or longer, then stick to it. The more you move in and out, the more likely you will have disastrous results.

If you hear a planner tell you he knows what's going to happen in the short term, ask him to let you see his crystal ball. See, if we actually had one, would we really need to make a living giving advice? If the mole's crystal ball really worked, I'd have the biggest house in Aspen!

The Mole is a certified financial planner and certified public accountant who - in the interest of fairness - thinks you should know what goes on behind the scenes in financial planning. Want to make contact? E-mail him at themole@moneymail.com.