Don’t get us wrong. Investors have plenty to worry about in fall 2016, from the uncertainty surrounding the presidential election to the weak US economy and sky-high equity valuations.
But investors often do more harm than good when they make hasty, dramatic moves—like trying to time a top in the broader market by selling all their stocks.
This caveat holds doubly true for anyone living off their investment income. Selling your stocks means tapping your savings while you wait for stocks to decline; the longer the market remains irrational, the less capital you’ll have to invest to generate future dividends.
Taking an incremental approach is the best way to reduce risk in the latter stages of a market cycle.
Shares of the weakest companies always suffer the most damage in bear markets; weeding out these names can dramatically reduce the danger embedded in your portfolio. Equally important, the proceeds from these sales provide some dry powder to redeploy during a selloff. And your stronger holdings will continue to generate income, keeping the cash flowing.
Even the best stocks feel the pain in a bear market. In the latter stages of this bull market, equity valuations have reached levels historically associated with major tops. And more than seven years into the lackluster recovery from the Great Recession, the US economy remains stuck in first gear and grew by less than 1 percent in the first half of 2016.
Meanwhile, the Federal Reserve has started to talk up a potential rate increase, causing gyrations in the bond and equity markets. And the uncertainty created by an impending presidential election always unsettles investors.
Momentum-seeking investors have bid up many defensive sectors; the Dow Jones Utilities Average, for example, trades at almost 19 times earnings—its highest multiple since before the 2001-02 crash. Shares of companies in the consumer staples sector have also been bid to the moon, while bond yields continue to bump along generational lows.
At these levels, even utility stocks and other defensive sectors could be at risk of a 20 percent to 25 percent decline over the next six to 12 months.
But high-quality dividend payers will continue to disburse cash to their shareholders throughout the selloff and will rebound with the broader market. Marginal fare, however, likely will sustain larger losses, especially if deteriorating business conditions or liquidity constraints force a dividend cut.
The S&P 500 has broken below its 50-day moving average and continues to bounce along its 100-day moving average. However, the benchmark index still remains within a few percentage points of its all-time high.
Timing a selloff in the broader market is a fraught enterprise. But we can acknowledge the growing risk of a pullback and make moves to protect ourselves by taking some partial profits off the table and paring exposure to riskier names.
Here’s our three-part strategy to help income-seeking investors keep the dividends coming while reducing risk and preparing to take advantage of future opportunities: