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business newsCut Volatility and Gain Some Income
Combining dividends with value stocks.
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Volatility. The very sound of it strikes fear into the heart of investors.
In an era of "flash trading" -- direct connections between hedge funds and exchanges and the hyper-kinetic selling frenzies that result -- the individual stock investor doesn't stand a chance.
If you're a day trader and can't keep up with these eye-blink trends, you're toast.
How do you beat the ultra-fast machines that have taken over trading? It's almost like an Isaac Asimov novel (see I, Robot) where humans have ceded control to software.
One way is to buy bargain stocks whose values haven't been fully recognized by the market. Another is to buy established companies that have been paying dividends for decades (See Contrarian Stock Picks With Dividend Income).
Fortunately, there's a salient way of combining both strategies. Equity-income mutual funds feature value stock picks and high yields. If you want to be in the market, but can't stand the bewildering volatility, these funds are good core holdings.
Over time, this strategy has been profitable. For the 10-year period through March 31, equity-income funds returned 3.8%, compared to a loss of 0.7% for the S&P 500 Index, according to No-Load Fund Investor, a newsletter that monitors and recommends funds.
The reasoning behind an equity-income fund is that they often hold ugly-sister stocks.
Established companies in out-of-favor industries such as utilities and financial services tend to pay high dividends. Most investors hold their noses when they buy them, unless, of course, they want dividend income, which acts as a buffer in any selling spree.
When the fur flies in selling routs, the dividend payers don't get hit as bad (Procter & Gamble (PG) being an exception during the May 6 sell-off). Their income gives them higher economic value than those without quarterly payments. They have profits to spare -- and share.
Another reason to buy equity-income funds is that they tend to do best during an economic recovery. They tend to have heavy weightings in energy, utilities, telecommunications, and consumer stocks. All of those sectors profit in a rebound.
For income investors, equity-income funds offer some handsome yields. The Vanguard Equity-Income fund (VEIPX) is paying a 2.7% yield, which is roughly triple what you'd get in a money-market fund.
The majority of the Vanguard fund is invested in large, bargain-priced companies and has outperformed the broad-market S&P 500 Index for the last decade.
If you're not as concerned about yield -- and want a lower-risk profile -- then take a look at the T. Rowe Price Equity-Income fund (PRFDX).
Yielding 1.6%, the Price fund focuses on out-of-favor stocks, mostly industrial, consumer, and financial service companies, according to No-Load Fund. Through May 21, the fund has produced a 10% gain year to date.
If you're looking for an equity-income fund that picks socially responsible companies, consider the Parnassus Equity-Income fund (PRBLX). The fund doesn't invest in companies that are connected to tobacco, alcohol, gambling, nuclear power, and poor environmental records.
Parnassus beat the S&P 500 (SPX) last year and over the past three-, five- and 10-year periods. That was due to a heavy position in undervalued technology, health, and industrial companies. It gained nearly 29% last year.
There's also a neat math fact involved in buying equity-income funds. If you keep reinvesting dividends, they compound over time, increasing your ownership stake and your total wealth.
Your nest egg builds up without you having to think about it. Dividend income buys new shares no matter what the market is doing.
Within a retirement fund such as an individual retirement account, the income and the capital gains of these funds are tax-deferred. Outside of a retirement vehicle, of course, you pay taxes on the distributions.
While equity-income funds are certainly not immune to market risk -- the Vanguard fund alone lost 31% in 2008 -- they can cushion the blow of the market's worst excesses. It's better to have a bit of protection during a storm, especially if you have no idea when the next typhoon is coming -- or how bad it will be.
New to investing? E*Trade can help. Click here to watch a series of brief educational videos like "New to Online Investing," "The Basics of Stock Screening," "Options for Beginners," and more.
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