Don’t Fall for a Trap! How to Invest in Dividend Paying Stocks

Charles Sizemore Economy and MarketsIn investing – heck, life in general – if something looks too good to be true, it probably is.

Nowhere is this more true than in the world of high-dividend stocks.

A generation ago, investors looked to the bond market for income. That made sense when you could get a safe yield of 8% or higher.

But at today’s puny yields, bonds aren’t going to cut it for most retirees. The 10-year Treasury yields about 2.1% as I’m writing this. That means you’d need to have $3.6 million invested just to generate an income of $75,000 per year.

Needless to say, most retired investors don’t have $3.6 million just lying around. Most don’t have one tenth that amount.

To make up for the money they don’t have in the bank, they’ve been committing that cardinal sin of investing: chasing yield in high-dividend-paying stocks.

Let’s say that you find a stock yielding a fat 10% in dividends. You can generate that same $75,000 with just $750,000 invested. Now, that’s still a lot of money, of course. But it’s a lot less than $3.6 million.

But there’s a problem with this. Remember, bond interest is a contractual obligation. If the bondholder doesn’t pay you, you can sue them. And if they fall into bankruptcy, you are first in line to get paid.

Not so with dividends. A company can cut its dividend at any time at the discretion of the board of directors. And as an investor, there’s not a thing you can do about it.

Dividends get slashed all the time. According to Street Insider, 837 companies have cut or eliminated their dividend this year alone, including large players like Freeport McMoran.

As recently as August, Freeport-McMoran was yielding nearly 10%. They were paying out a quarterly dividend of $0.313 per share. Now? A lousy $0.05 per share.

I’m not going to tell you to dump all of your dividend-paying stocks. But I am going to give you some advice on how to better think about dividends.

To start, longevity and growth are far more important than current yield.

The longer a stock has paid a dividend, the less likely it is that dividend will be cut. Sure, a crisis can always come out of the blue – think the 2010 Gulf of Mexico oil spill that clobbered BP – but if a company has managed to pay and grow its dividend for multiple consecutive decades, this is a company that can likely survive a zombie apocalypse.

The next point to remember is the payout ratio.

This can be defined differently for different types of stocks. For example, REITs and MLPs use different accounting terminology.

But the concept is the same. A healthy company should be paying out considerably less in dividends than it takes in as earnings and cash flow. It’s not sustainable for a company to pay out more than it makes.

Still, it never ceases to amaze me how investors routinely get suckered into yield traps like these.

So, if you want a durable income portfolio to tide you over in retirement, repeat after me:

  1. Don’t chase yield!
  2. Don’t risk dividends just because they pay out more than bond interest!
  3. And don’t trust a company that pays out more than it takes in!

Trust me, you’ll thank me later.

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Charles Sizemore
Editor, Dent 401k Advisor

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Charles Sizemore is a research analyst with Dent Research. His primary research focuses on income, retirement strategies and fundamentals.