TFSA Investors: Don’t Chase Yield — Do This Instead

There are few habits that investors get into that cause them more grief than yield chasing.

Yield chasing–which involves picking a portfolio of high-yield stocks with the aim of achieving extremely high dividend returns–often causes investors to miss the forest for the trees, putting yield above overall investment quality. Although it’s nice to get some income from one’s investments, the yield must not take precedent over all else. If you prioritize yield above all other considerations, then you’re most likely to suffer an inferior investment result. This is the problem the yield chaser faces.

A classic example of yield chasing

To understand what yield chasing is all about, it helps to look at examples. There is no stock that is inherently a “yield chaser” stock, but some lend themselves well to yield chasing behaviour.

One TSX-listed stock that many yield chasers own is Enbridge (TSX:ENB). The stock has, for much of the last 10 years, had a dividend yield above 7%. The yield is lower today (about 5.3%), but has been as high as 12%.

Because of the high yield involved, Enbridge stock is owned by many yield chasers. The problem here is that Enbridge stock might not be the best fit for every investor’s portfolio. While ENB stock has done well historically, delivering five and 10 year total returns slightly higher than those of the TSX index, it hasn’t done so without risk. The underlying company has a very high payout ratio and delivers negative free cash flow (FCF) not infrequently. An investor who put all of their money into Enbridge would be taking a very high level of risk in exchange for a little more dividend income. The phrase “penny wise but pound foolish” comes to mind here.

The risks of yield chasing

Yield chasing comes with several major risks, some of them large ones. These include:

1. Excluding high-quality assets from your portfolio. If you insist that all assets in your portfolio have high yields, then you’ll exclude lots of low/no yield assets that have high growth and compounding potential.
2. Elevated income volatility. Very high-yielding stocks experience dividend reductions and cuts more frequently than low/moderate-yielding stocks.
3. Concentration. Very high yields are usually found in specific sectors such as real estate investment trusts (REITs), midstream energy, and occasionally financials. They are almost never found in the tech sector. So, investors who chase high yield are likely to find their portfolios highly concentrated in only a few industries.

The net effect of the three factors above is that they put the yield chaser at risk. The possibility of lagging the market is very real here. In the next section, I’ll explore what to do instead of yield chasing.

What to do instead

Instead of chasing yield in your portfolio, you should strive to create an adequately diversified, uncorrelated portfolio. “Diversification” means holding a large number of assets in your portfolio. “Uncorrelated” means that the assets in a portfolio don’t move together in the same direction. Diversified, uncorrelated portfolios are known for delivering satisfactory returns at low levels of risk.

You can achieve a diversified, uncorrelated portfolio by using low-fee index funds. Such funds hold broad swaths of the market, giving them a high degree of diversification. Sometimes, index funds’ underlying components are correlated with one another, but you can achieve low portfolio diversification by holding a collection of funds (e.g., a stock fund, a REIT fund, a bond fund, etc). The yield on such a portfolio will not be as high as that achieved by yield chasing, but it will be much more sustainable. Over the long run, it’s a winning strategy.

The post TFSA Investors: Don’t Chase Yield — Do This Instead appeared first on The Motley Fool Canada.

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More reading

• How to Generate $500/Month Tax-Free Using a TFSA
• An Ideal TFSA Stock With a Steady 5.3% Yield
• Market Turbulence Ahead? Take Shelter With 2 Handpicked TSX Stocks
• The 3 Dividend Stocks I Think Every Investor Should Own
• Where I See Enbridge Stock Heading Over the Next 3 Years

Fool contributor Andrew Button has no positions in the stocks mentioned. The Motley Fool recommends Enbridge. The Motley Fool has a disclosure policy.