Within the last 8 months, I’ve had two prospects come to me for a portfolio analysis. They wanted to double check their current advisors. This is common during a bad market. Both prospects had large positions in preferred stock that paid dividends. These dividends served as their main source of income during retirement. Because they were dividends fromÂ preferred stocks, they also offered opportunity for growth. Is this a good investment strategy? While their situations are unique, there are three things everyone should consider when investing in preferred stocks:
1. Risk– Are there enough different stocks in your portfolio to diversify you?
2. Taxation – Are you paying unnecessary tax?
3. Investor Return – Can you hold the investment in bad times, or will you dump it?
Risk– When you invest in individual stocks, you have to make sure that you are diversified. You should own different types of stocks like Bank of America (large company), UMB Financial Corp (small company), Royal Bank of Scotland (international developed country company), and Bank Bradesco (international emerging country company). This creates an asset allocation. Studies have shown that asset allocation could account for up to 90% of your portfolio return. You also need to diversify across sectors. If you owned the 4 stocks mentioned, you would only hold financial stocks. This introduces sector risk. If the financial sector struggles, you struggle. One of the prospects I saw was heavily invested in the financial sector, and suffered for it.
Taxation – When you own dividend or interest paying investments like preferred stocks in a non-IRA account you pay tax on the income. If you plan on spending the income now, this strategy works. If you invest in preferred stocks for the bond/stock diversity, you may be paying unnecessary taxes. You might consider putting income and dividend producing investments in your IRA because an IRA defers tax until you withdraw the money. Then you can put appreciating stocks in your taxable accounts. Remember to keep your overall asset allocation intact.
Investor Return – Investor return is not the same as the investment’s return. In other words, people rarely hold on to a stock or fund long enough to achieve their actual returns. Most investors sell when the stock is doing poorly, and buy when it is doing well. I’ve covered this in my previous post 3 Biggest Mistakes Most Investors Make In both cases, the investors that came to me where being told by their advisors to frequently switch their stocks during market swings. Unfortunately, unnecessary commissions and bad timing was causing these investors to lose money. It is best to pick an allocation you are comfortable with, and can hold for a long time. Hopefully your return will be at least equal to market returns.
Are prefered stocks good for retirement income? Maybe. But I’d make sure that you were well diversified to reduce risk, invest in them in your IRA, and try to pick stocks you can hold.