One concerning aspect of dividend investing is that it can be easy to be attracted to stocks with the highest yields. Suppose a company’s share price lowers, which causes its yield to increase. In that case, it means that the market has discounted something it doesn’t like about the particular stock, or in other cases it can be due to feeling less positive about the market in general. Either way, the market’s trepidation should be taken as being correct in the first instance, and not as good thing yields are rising as price falls.
The issue with dividends is that those payments need to come from somewhere. Dividends are paid out of a company’s retained earnings, and after they have been issued to shareholders, the company’s stock price falls by an equivalent amount. Just as market efficiency discounts poor outlooks about a stock, it also knows that when a company pays out $1 of its earnings it should be logically worth $1 less on an absolute level. Investors then get $1 now instead of seeing $1 worth of unrealized capitalized gains, which can be a good or bad thing depending on how you view it - but generally, corporations would be pointless if shareholders were unable to participate in a company’s profits except thru speculation.
Similarly, some types of stocks, such as real estate investment trusts (REITs), which are required by law to pay out 90% of their retained earnings as dividends, may also suffer from the issue of being both attractive and risky opportunities. Although the most popular REITs like Getty Realty Corp (NYSE: GTY) or Service Properties Trust (NASDAQ: SVC) may be no more or even less risky than equities on the whole, the problems start when investors have too much exposure to them in their portfolios, often due to their yields, but more so due to the idea that they provide distinct diversification to equities.
Correlations
The issue with using REITs to diversify an investment portfolio, is that studies show that these instruments and equities show a positive correlation across many historical time periods. Often, when stocks go up, REITs go up, when stocks go down, REITs go down. Sometimes they diversify a portfolio, but their utility in this respect is nothing special.
However, a good thing for REITs is that by design they provide high dividend income which could offset some of these losses in an investor’s equity portfolio.
But REITs do outperform
On balance, REITs do have one negatively-correlated aspect to equities in general: they thrive in high-interest, and high-inflation environments.
Inflation increases the rents REITs can charge and boosts their total assets' prices. An overheated economy and high inflation then necessitate higher interest rates to cool it down, which then increases rent inflation even more. With loans being more expensive to acquire via higher rates, commercial developers and homeseekers are incentivised to rent existing property instead, leading to a constricted supply and higher prices.
The expected result of an increase in interest rates is also a constriction of economic activity, which burns the candle at both ends for the property market. When rents rise, they almost never come back down again, and the new price becomes a normalized event moving forward. Economists fear this, as it puts pressure on workers to ask for higher wages, which forces businesses to hike prices, and then people are always moving back to square one again. Hence, central banks would prefer an engineered recession over persistently high inflation.
Considerations
There are a lot of positives about REITs, but they are only mediocre diversifiers at best. It almost goes without saying that losing money is the worst thing to happen to your portfolio. If you are down 10%, you need 11% to get back to even. If you are down 50%, you need 100%. There’s also proof that low volatility portfolios beat ones that take high risk over long periods of time, such as the 60/40 portfolio of stocks and bonds beating pure-play equity portfolios.
Investors therefore should seek balance if they want exposure to real estate, as well as consider buying assets that are negatively and uncorrelated to fluctuations in the broader markets. Gold, art, wine, and jewelry are all alternative assets worth exploring.
