A popular question from my friends is “Where do I go for income in this low-yield environment?” There isn’t an easy answer.

Here’s why: Yields on money market funds are near 0%, and long-term Treasury bond funds are yielding below 3%. Vanguard’s Total Bond Market Index Fund is currently yielding 2.4%*, as of November 3, 2011. And for muni bond investors, our Vanguard Intermediate-Term Tax-Exempt Fund has an SEC yield of 2.55%* as of November 3, 2011, based on its current holdings.

With a yield environment on broad fixed-income portfolios appearing less than appealing to many, the queries then turn to the merits of dividend-paying stocks. In fact, a friend of mine the other day concluded that it was a no-brainer to substitute dividend-paying stocks for bonds in his portfolio since the dividend yield on the stock fund was higher than the yield to maturity in the bond fund. Plus, as he put it, he “gets upside” should stock prices rebound, versus the prospect that bond prices decline as yields go up.

No disrespect to my buddy (who shall remain nameless), but I dislike “no-brainer” investment strategies for a number of reasons, not the least of which is that it implies that I don’t use my brain in the decision-making process.

I’d like to point out that dividend-paying stocks are not bonds. Indeed, by their name, they are stocks, and thus are going to possess more of the risk-and-return attributes of stocks than bonds. As one can see by the chart below, income-focused stock funds, be they dividend-paying funds or REIT funds, tend to correlate with the broader equity market.

Indeed, this is especially true in down stock markets, as even this past summer reminded us. At times dividend-paying funds may outperform the broader equity market (as they have over the past several years), and vice versa. But, as the chart illustrates, if you substitute dividend-paying stocks for bonds in order to generate greater income, the final result is a more aggressive and more stock-heavy strategic asset allocation. In doing so, we would expect an increased likelihood of higher nominal returns over long periods of time, yes, but that’s not necessarily because of the higher anticipated income stream. Rather, it’s because stocks are riskier and more volatile than bonds.

Vanguard believes it’s important for investors to view their portfolios from a total return perspective, rather than simply in terms of potential income (i.e., the yield to maturity on a bond fund, or the dividend yield on an equity fund). An investor looking at total return will be concerned with capital gains and losses, as well as with the income derived from bond interest and stock dividends. Vanguard research has highlighted the importance of understanding total return and the risks that can accompany a narrow focus on income.

If you hope to gain more income by increasing your allocation to higher-yielding bonds or dividend-paying stocks, you should be aware that your portfolio volatility will likely increase as a result. In finance jargon, such a change in strategic asset allocation is a “move to the right” along the expected-return frontier. Our graphic could serve as a reminder that, while an allocation to a conservative bond fund may provide below-average total returns in the next decade, the volatility-dampening properties of bonds should be carefully taken into consideration when developing a sound investment strategy.

While I certainly sympathize with investors grappling with this low-yield environment (see my July 12 post, Monetary policy’s sacrificial lambs), I just hope that we all appreciate that dividend-paying stocks are not substitutes for Treasury bonds. That’s not to say that dividend stocks will not outperform a broad bond portfolio over the next several years. Rather, it’s simply to say that such an income-focused strategy is not a no-brainer, nor is it risk-free.

Growth of $100: December 31, 1997–October 31, 2011

Growth of $100: December 31, 1997–October 31, 2011

Sources: Vanguard, Dow Jones, MSCI, Standard & Poor’s, FTSE, and Barclays Capital. U.S. stocks are represented by the Dow Jones Wilshire 5000 Index through April 2005 and the MSCI US Broad Market Index thereafter. Dividend stocks are represented by the S&P 500 Dividend Aristocrats Index through December 2003 and the FTSE Dividend Yield Index thereafter. REITs are represented by MSCI US REIT Index. Bonds are represented by the Barclays Capital US Aggregate Bond Index. Many of the stocks in both the Dividend Stocks and REITs categories, as represented by the underlying indexes, could be a subset of the broader U.S. Stocks category.

The time period covered by this illustration (December 31, 1997–October 31, 2011) was chosen because it encompasses both bull markets and bear markets. It also helps to illustrate the volatility that accompanied the asset classes in question during times of market volatility. Vanguard evaluated other time periods, with similar results.

Dividend yields and yield to maturity are as of September 30, 2011, for the Vanguard funds in question—Vanguard Total Stock Market Index Fund, Vanguard High Dividend Yield Index Fund, Vanguard REIT Index Fund, and Vanguard Total Bond Market Index Fund.

Annualized return refers to the practice of extrapolating investment returns for a period of less than a year so that they apply to a full year, typically for purposes of comparison.

Standard deviation is a measure of the degree to which a fund’s return varies from its previous returns or from the average of all similar funds. The larger the standard deviation, the greater the likelihood (and risk) that a security’s performance will fluctuate from the average return.

REITs are included in the chart because they have historically tended to have higher yields than other types of investments. Since they are required to pass the majority of their earnings on to shareholders in the form of dividends, REITs are often a popular choice for dividend-seeking investors.

* Based on holdings’ yield to maturity for the preceding 30 days. Distributions may differ.

Notes:

• All investments are subject to risk. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.

• Investments in bond funds are subject to interest rate, credit, and inflation risk. U.S. government backing of Treasury or agency securities applies only to the underlying securities and does not prevent share-price fluctuations. Unlike stocks and bonds, U.S. Treasury bills are guaranteed as to the timely payment of principal and interest.

• Funds that concentrate on a relatively narrow market sector face the risk of higher share-price volatility.

• The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.