Utility stocks represent ownership in the gas, electric, water and other public service industries that we all generally use in our daily lives. Because these industries benefit the public good, they are traditionally regulated by various governmental sources. As a result, utilities generally have relatively stable earnings, pay higher dividends and are considered to be among the more conservative types of stocks. Being overweighted in utilities can still have its risks, including falling stock prices and dividends.
Lack of Diversification
The risk of being overweighted in utilities is the same as in any non-diversified portfolio. The mere fact that you own companies in only one industry increases the risk profile of your portfolio, even if the stocks themselves are individually "lower-risk." Bill Sharpe, one of the co-authors of modern portfolio theory, points out that there are three levels of risk in owning a stock -- company risk, industry risk and market risk. While most portfolios are subject to overall market risk, having a portfolio in a single industry also subjects you to industry risk. If you were to diversify your utility holdings with stocks of additional industries, you could help mitigate the risk of being invested in just one industry.
Utility stocks generally pay relatively high dividends, which is one reason why many conservative investors are attracted to them. The relative predictability of a utility's dividend can play an important role in the portfolio of an investor who needs a steady stream of income, such as a retired investor. While utility stocks can go up and down in value, just like any other type of stock, investors generally do not look for major capital gains in utility stocks. Over the long run, a utility stock will generally get most of its return from its dividend, rather than from capital gains. As such, utilities are known as income stocks. Since long-term capital gains are taxed at a more favorable rate than income, such as the payments from a utility dividend, investors in a high tax bracket may also have more tax consequences than investors buying more growth-oriented stocks.
Rising Interest Rates
Since utility stocks generally pay higher dividends, their stock prices are more susceptible to rising interest rates than other stocks. Much like a bond, prices of utilities generally go down when interest rates rise. If rates rise, making higher dividend yields available in the market, investors will tend to sell existing shares and buy new, higher-yielding investments. This can drive utility prices down until the company either raises its dividend or sees its yield rise to current market levels. Having no other types of investments could result in your entire portfolio going down in the face of rising rates.
While utility dividends in general are fairly reliable, the promise of a dividend is only as good as the ability of the utility to generate earnings. If a company misunderstands its costs, receives less-than-expected revenue or has other misfortunes, it may have to cut its dividend. In addition to the reduction in income, utility investors could see a drop in the share price of the utility's stock. While this financial misfortune could be contained to a single company, it's possible that an industry-wide phenomenon could result in lower rates for all of your utilities. Without other investments to balance out the reduced dividends, your portfolio could see a substantial drop in income.
- Dividend Growth Investor: Don't Chase High Yielding Stocks Blindly
- Money Morning: How to Use Utilities Stocks to Pump Up Your Portfolio
- The Motley Fool: Dangerous Dividends
- ResourceConsulting.com: The Risk of a Non-Diversified Portfolio
- The Free Dictionary: Income Stock
- IRS: Topic 409 -- Capital Gains and Losses
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