The Risks of High-Dividend Investing
A few years ago I was asked by a client if we should consider moving a significant portion of their stock investments into dividend-paying stocks. I can understand their perspective – the promise of regular, consistent dividends can be tempting, especially for retirees on a mostly fixed budget. For example, a retiree who owns $1,000,000 of ABC high-dividend stock fund that pays them $50,000/year in dividends can provide a sense of security.
However, investing in companies solely for their high dividend can introduce a number of risks that investors should be aware of.
Yield trap - Some companies artificially boost their yields by either paying out a substantial portion of their earnings as dividends or even by borrowing money to fund the payouts.
Investor pressure – Once companies start paying a high dividend, they face immense pressure from shareholders to maintain and grow that dividend. That can create a conflict when during a normal business cycle downturn, a company refuses to cut a dividend even when it would be prudent to do so.
Low growth potential – Before investing in any company with a high dividend, you should ask yourself why it is a better use of funds to pay out such a high dividend instead of reinvesting it back into the business. It may be because there is not much growth potential, which raises concerns for its long-term health. Consider some of the past high-dividend stocks – Kodak, RadioShack, and Barnes & Noble.
Sector concentration – most high-dividend companies are concentrated in a few sectors, specifically banking, utilities, and consumer staples among others. An investment strategy that solely invests in these sectors lends itself to an overall lack of diversification.
Dividend cuts – Lastly, companies are not required to keep their dividends. In the 2008-2009 Financial Crisis, we saw many companies cut their dividends to stay alive. The security of a steady income stream disappeared just when investors needed it most.
While dividend-paying stocks can and often should play a role in a retiree’s investments, it is rarely the single solution for a well-balanced portfolio. A company’s dividend should not be the only reason for owning a stock. When you buy a stock or a collection of stocks in a fund, consider its ability to sustain that dividend over time and then continue to monitor and reevaluate your positions over time.
Happy Planning,
Alex
This blog post is not advice. Please read disclaimers.