(Bloomberg) — If your client wants a consistent stream of income when they retire, they’ve probably heard about a few familiar investment strategies. A dividend-paying stock gets investors a regular cash payout from a company while letting them participate in the stock market’s upside. Municipal bonds are safely backed by governments, and their income usually isn’t taxable.
But after years of low interest rates and rising stock markets, these once-conservative strategies might actually be putting investors in risky situations. Here’s where these income investors are going wrong:
1. They invest too narrowly.
When online investment firm SigFig analyzed 300,000 investors’ portfolios, it found that people who are focused on income — rather than growth — are getting most of that income from just a few sources. Of income investors over the age of 40, 52% are getting their income entirely from three or fewer dividend-paying stocks. Thirty-one percent are relying on only one dividend-paying stock.
“Being so concentrated in a few income-generating stocks is dangerous,” says
2. They’re falling for sales pitches.
With interest rates so low, many older investors are desperate for income. Some brokers are taking advantage of that desperation to sell investors products that are expensive, overly complicated, and wrong for their particular situations. That’s the conclusion of a new report from the
3. They’re betting on overvalued investments.
Pinning your client's retirement on just a few companies is risky enough. But the current state of the stock market adds to the risks: By historical valuation standards, U.S. stocks that pay a dividend are looking expensive, Hsu says. The Dow Jones U.S. Dividend 100 Index is up 181% over the past six years. Those prices reflect high expectations that could be dashed if profits or the economy stumble. If people are willing to invest in companies based outside the U.S., Hsu says, they can find companies paying healthy dividends at more reasonable valuations.
Municipal bonds — debt backed by cities, states, and other local governments — have also had a great run lately, with the S&P Municipal Bond Index returning 5.8% in the past year. Muni bonds can be tax-free, and that’s made them popular after recent tax increases on wealthy Americans, says
4. They’re taking risks.
Unfortunately, investors are drawn to the riskiest bonds because they also offer the biggest payouts. The riskiest muni bonds, for example, are issued by governments with fiscal trouble, including
High-yielding stocks, which Hsu calls “junk stocks,” have the same risks. Dividend payouts at troubled companies may look generous, but there’s a good chance those companies won’t be able to keep paying them. “You’re picking up a lot of risk,” Hsu says.
Income investors may not be able to avoid risk entirely. With stocks at record highs and interest rates at record lows, it’s harder and harder to find an income that’s perfectly safe. To get the income they need, clients need to protect themselves by spreading their assets among as many income- producing investments as possible. And they should beware of any investment that promises a big payout — it’s almost certainly too good to be true.
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