How do you know if your income-oriented investments are paying as much as they could, and without too much risk?
It can be a dilemma for an investor shifting focus from growth to income. In the decades devoted to growing the portfolio, there are plenty of benchmarks for gauging performance. If your fund of big-company stocks trails the S&P 500 index, you know you could do better. If you beat the benchmark you can celebrate or look closer to see if your holdings are too risky.
Income-oriented investors like retirees have benchmarks, too. But comparisons aren’t always so easy. If you have a fund or individual stocks aimed at producing dividend income, an index like the S&P 500 might not be suitable, since most of its performance comes from rising share price rather than its modest dividend earnings, currently just under 2 percent.
[See: 9 Tips to Conquer Fire: Financial Independence, Retire Early.]
“For most retirees, the S&P 500 is not a suitable benchmark,” says Matt Hylland of Hylland Capital Management in North Liberty, Iowa. “More than likely your portfolio has a significant amount of bonds by the time you near retirement and comparing their performance relative to large-cap stocks is not useful.”
Bond investors can judge performance against the gold standard, the 10-year U.S. Treasury note, now yielding about 2.8 percent. But that may not be a good benchmark for riskier corporate or municipal bonds that pay more than Treasurys. Fortunately, there are bond indexes too.
“We believe that investors should know what the safe side is supposed to be doing compared to peers,” says Nicholas J.D. Olesen, director of private wealth at Kathmere Capital Management in King of Prussia, Pennsylvania. “We utilize the U.S. aggregate bond index and total bond index as our gauges for those that are predominately fixed-income focus.” Performance of each can be found by searching the names online.
The pros have some tips for telling how your income-producing investments are doing:
Read fund materials. Actively managed funds typically describe the benchmarks they use in the prospectus and other fund documents. Once you find it, tracking down the index online is an easy matter. Then you can watch to see if your fund is doing better or worse.
Fund documents can also reveal benchmarks outside of the mainstream, like those used to measure real estate investment trusts and other less common investments.
Services like Morningstar provide comparisons between individual assets and suitable benchmarks.
Find a stand-in. It’s fairly easy to find a benchmark for an individual stock, bond or fund, but harder to gauge a portfolio as a whole. So Hylland says he looks for a target-date fund with an asset mix similar to his client’s portfolio.
[See: 9 Dividend Stocks to Sell Despite High Yield.]
“I compare portfolio returns to a target-date fund that would be suitable for a client for a better gauge of relative performance,” he says. “Although not every target-date fund or client is the same, it provides a benchmark that corresponds approximately to a portfolio with a similar amount of fixed income.”
Target-date funds, offered by many major fund companies, hold a mix of stocks and bonds deemed suitable for an investor with a given retirement date. As the date approaches, assets are shifted from stocks to bonds to emphasize safety. While an investor may not find a target-date fund that mirrors a custom portfolio exactly, a target-date fund with a similar mix of holdings will show what the investor could earn by taking an easier path.
For assessing dividend income, Magdalena G. Johndrow of Johndrow Wealth Management in Hartford, Connecticut, recommends comparing with stocks in the list of dividend aristocrats. Those are stocks that have raised dividends for each of the previous 25 years. That will show what you could earn with a stock that has performed well over time.
Find other measures. Measures like standard deviation provide insight into an investment’s volatility. Hylland also recommends simply looking at how the investment did during bear markets. If the market plunged 20 percent and your holding lost 40 percent, that’s a red flag.
Don’t get greedy. Experts say the big danger is swinging for the fences — hunting for the biggest yield you can find. Often, a high yield is a sign of danger, and what you earn in interest or dividends might be lost when the market catches on and your security’s price collapses. Smart benchmarking will give an insight into risk as well as a guide to what could be earned in current market conditions.
“We believe there is too much risk if you find or take on one of the following: yield over 5 percent and duration over five years,” Olesen says. “Both are signals that the risk is too high, especially given interest rates now.”
A five-year duration means a bond or bond fund could lose 5 percent of its value for every 1 percent rise in prevailing interest rates.
Use index funds. If you have trouble finding a suitable benchmark, perhaps your holding is too unusual and risky.
[See: 7 Shipping Stocks to Buy for Dividends.]
The simplest solution is to use index funds that by definition track a mainstream index. There are multitudes of index funds covering the broad market and small slices of it, as well as index funds for less-common holdings like REITs and preferred stocks. With an index product you know exactly what benchmark to use — it may even be included in the fund’s name.
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