Beware These 4 Traps With Your Dividend Portfolio

Even as focusing on dividend-paying stocks is a sensible strategy, doing so doesn't come without pitfalls

Christine Benz 23 August, 2016 | 15:23
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Is it any wonder investors have been gravitating to dividend-paying stocks? Of course, there's the oft-cited statistic that dividends have composed roughly 40%-50% of the U.S. market's long-run return. (The variations have to do with the specific data sets and time periods being examined.) And current bond yields make stock dividends look even more tempting than usual: The yield on the S&P 500 is currently higher than that of the Barclays Aggregate Index, a phenomenon that has happened on just a few occasions over market history.

No doubt about it, dividend payers can and should be an important part of investors' portfolios. But even as focusing on dividend-paying stocks is a sensible strategy, doing so doesn't come without pitfalls. Here's a closer look at some of the most common ones investors should be aware of today, whether they're investing in individual dividend-paying stocks or mutual funds focused on dividends.

Pitfall 1: Not paying adequate attention to valuation

A juicy dividend yield can signal a stock is a good buy, which helps explain why dividends are a key first screen for many value investors. For example, let's say a company that was trading at $30 a share pays a $1 per-share dividend; its dividend yield is 3.3%. But if the share price drops to $20 and the company maintains its dividend of $1 a share, its dividend yield would spike to 5%.

But dividend payers have enjoyed a good run recently, in part because the income stream investors earn from bonds has slowed to a trickle. The net effect of increased demand for dividend payers is that not every stock with a tantalizing yield is attractively valued at this point. Of companies with Morningstar analyst coverage and dividend yields of more than 2%, for example, about 18% currently earn 4 or 5 stars; meanwhile, a higher percentage--roughly a fourth--of the companies with yields of zero currently earn 4 or 5 stars. And some dividend payers are quite overvalued at today's levels; 31% of companies with robust, 2% dividends currently earn 1 or 2 stars. That's not meant to be a blanket statement that dividend payers are expensive and should be avoided, but it does serve as a reminder that a company with a fat dividend yield is only attractive at the right price.

Pitfall 2: Not emphasizing low costs in the realm of managed products

Dividend investors don't just need to focus on price at the security-selection level; if they're buying some type of a dividend-focused managed product, such as a mutual fund or exchange-traded fund, overpaying can also be costly. That's because fund expenses are paid first from a fund's yield and then from its return. From a practical standpoint, that means that a high-cost fund or ETF must take extra risks to deliver a yield that's competitive with payouts of its cheaper competitors. That explains why Morningstar's favorite dividend-focused mutual funds and ETFs, both "yielders" and "growers" tend to be low-cost relative to their peers.

Pitfall 3: Using them to supplant bonds

As interest rates have trended down, some income-minded investors, especially retirees, have emphasized dividend-paying stocks at the expense of bonds. That's reasonable--but only to a point. That's because the role of high-quality bonds in investors' portfolio is not so much as a return engine but as a shock absorber. When the economy and the equity market are trending down, high-quality bonds will lose less than stocks and may even gain in value. Dividend-paying stocks, meanwhile, may lose less than the broad equity market in times of duress, but they'll still incur losses. Thus, while it's not unreasonable for investors to steer a small share of their bond allocations to dividend-paying equities, making a wholesale swap will jack up the portfolio's volatility and risk level.

Pitfall 4: Underestimating their sensitivity to interest-rate changes

One of the reasons that dividend-paying stocks have performed well recently is that bonds have been such weak competition from a yield standpoint. But when interest rates trend up, bonds can give dividend payers a run for their money: Assuming equivalent yields, many income-focused investors would prefer to own a bond, which is further up in a company's capital structure and therefore safer in case of bankruptcy or forced liquidation, than a stock. Thus, it's not unusual for dividend-paying stocks, in particular, to feel a tremor when bond yields trend up.

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About Author

Christine Benz  Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz and on Facebook.

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