Understanding volatility in income paying investments

Posted on September 17th, 2012.

When it comes to buying income paying investments some things never change. Once such “thing” is the tendency for a high yield to catch the eye of an investor like a tall glass of lemonade on a hot day. Now of course the yield of an investment is an important factor in the decision making process, but it’s not just the yield, but also its safety that is important – will the investment continue to pay that yield? Has the yield of the investment fluctuated in the past? And if so why does that matter?

Well, in a nutshell, the reason it matters if a yield is lowered is that it will likely have a negative impact on the price of the units. The amount of impact a cut in a dividend or distribution has on the unit value versus another investment is a comparison on volatility. If an investment fluctuates a great deal then it is said to have “high volatile”, whereas if an investment does not fluctuate very much it said to have “low volatility”.

But how about the flip side? Can this volatility help us on the way up? Will it go up more? Yup, most likely, and in my book I explain how to set up a portfolio that is in the right types on income paying investments at the right times – I call it an InSync Income Portfolio.

Comparing volatility between different investment choices in the same sector can be quite illuminating. For example, you might find that two stocks have a similar dividend, but one is half as volatile. Most investors want high yields with lower risk of “capital depreciation”, so this is important information.

So how do we measure volatility? Well a common way is by comparing how much a stock fluctuates versus a market index, also known as the Beta of a stock. A  Beta of 1 would indicate the stock has the same volatility as the market, a stock Beta of 0.50 would be half as volatile, and 1.5 would be one and a half times as volatile. So you are likely starting to see how this information can be helpful.

In my acclaimed book: InSync Income, The Must Read Guide to Investing for Income in Canada, I take this idea further by introducing an entirely new way to compare income producing investments, the Dividend Anchor Score. The Dividend Anchor Score compares the volatility of an investment to its dividend or distribution. The DA score has been found to be predictive in certain ways, with higher scoring stocks tending to have fewer historical dividend cuts.

You can learn more about the DA score by buying my book. In addition, take a moment to review a recent study done in collaboration with Hamdi Driss, a member of PHD Research (Finance) at York University’s Schulich School of Business. Schulich was named #1 business school in Canada and in the top ten business schools in the world- Economist Global MBA ranking(2010)  The study: The Weiler Dividend Anchor Score, Exploring the usefulness of the DA score as a security analysis tool, features research of oil & gas stocks on the Toronto Stock Exchange.

What do I want you to take away from this post? Firstly, please understand that it’s is not just the yield of an investment but its safety that is important. Secondly, this topic is bigger and more important than it seems. I would recommend reviewing chapter 2 of InSync Income.

Having a relationship with a financial advisor is key. All the reading in the world can’t replace the experience of your advisor. I always recommend seeking advice from an appropriate financial professional prior to changing or implementing any financial strategy. Invest with advice for best results.

Frank Weiler

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