A rose by any other name would smell as sweet.

With bond yields so low, is it a good idea to substitute dividend-paying stocks for bonds? Some would say yes, since dividend-paying stocks yield more than some bonds, and have more upside potential.

However, I don’t think this is a good strategy.

Obviously, dividends are an important component of stocks’ total return. From 1930 through October 2010, for example, dividends provided 45% of the annualized percentage gain of the S&P 500. Dividends also help sustain portfolio income when interest rates are low.

But there’s no getting around the fact that stocks, including dividend-paying stocks, are generally more volatile than bonds. Substituting dividend-paying stocks for bonds will lead to a higher risk portfolio.

Let’s take an example of how volatile dividend-paying stocks could be. We’ll look at three exchange traded funds (ETFs). The first is SPY, which tracks the S&P 500.

The second is SDY, which tracks the S&P High Yield Dividend Aristocrats index. This index starts with the entire U.S. market excluding the smallest 10%, and then chooses the 50 highest dividend-yielding stocks which have consistently increased dividends every year for at least 25 years. The dividend yield on SDY was 3.24% as of 12/27/10.

The third ETF is IEI, which tracks the price and yield performance of the Barclays Capital 3-7 Year U.S. Treasury Index. The recent 30-day yield on IEI was 1.65%, as of 12/23/10.

The stock market peaked October 9, 2007 and reached its subsequent low on March 9, 2009. This table shows what happened to the prices of the three funds (adjusted for dividends) between those two dates:

TickerChange in price from 10/9/07 to 3/9/09
SPY-55.2%
SDY-53.5%
IEI14.3%

Investors with all-equity portfolios incurred large losses. The emotional turmoil persuaded many of them to exit the market and, in most cases, miss out on the better times which eventually came around.

Every investor should determine an asset allocation, most likely including bond funds for stability and safety. The exact allocation is usually based on a variety of things, including the investor’s time horizon, current assets, desired future goals, and risk tolerance.

Once that asset allocation is determined (for example, 60% stocks, including a wide variety of U.S. and international stocks, and 40% bonds), the investor should periodically rebalance the portfolio to get back to those predetermined weights, without making major tactical shifts between the asset classes.

A rose by any other name is still a rose, and a dividend-paying stock is still a stock—and should be treated as such.