There is a lot of potential for financial success when you invest in dividend stocks, but with great rewards come great risks (if you’re not careful with your investment strategy, of course). A common mistake that investors from all backgrounds and experience levels sometimes make is focusing on high dividend yields without paying much attention to the risk involved with that high yield. Simply put, don’t chase high yields!
After all, pursuing an investment strategy that will generate monthly passive income through dividend-paying stocks presumably means you shouldn’t be too concerned about the stock’s value as long as the dividend payouts keep coming, right?
Wrong! There are multiple factors you should consider when it comes to investing in dividend yield stocks, and it’s important to note that a high dividend yield percentage doesn’t always mean you have a solid investment in your portfolio. In some cases, you might be inadvertently investing in a “dividend trap.” If you want to protect your portfolio from the hidden pitfalls of unrealistically high dividend yields, let’s unpack what “dividend traps” are and how you can avoid them:
What is a Dividend Trap?
A dividend trap (AKA: “dividend yield trap”, “yield trap” or “value trap”) involves unsustainable dividend yields from stocks that are either stagnant or plummeting in share value. While you may get some great returns when you initially invest in stocks with unusually high dividend yields, it’s pretty likely that those dividend payouts will be cut eventually when the stock price decreases (in more extreme cases – such as Windstream Holdings [Ticker $WIN] in 2017 – the dividend was eliminated altogether).
The old adage, “if it sounds too good to be true, then it probably is” applies well in these circumstances because double-digit dividend yields are frequently unsustainable in the long-term. A company that does not adapt cannot grow indefinitely and market conditions are constantly in flux, which means that stock prices will inevitably decrease to some extent as companies regroup and the markets adjust.
For example, a stock trading at $100 a share with a 4.5% dividend yield looks much more favorable for dividend investors if it decreases to $50 per share (which pushes the dividend yield up to 9%). As you can see here, focusing too much on the dividend yield and not enough on past and present prices of the stock itself can be detrimental for your dividend portfolio, so it’s important to avoid dividend traps by thoroughly examining multiple aspects of a stock before diving into the investment pool.
Dividend Payout Ratios
One way to avoid a dividend trap is by evaluating a stock’s dividend payout ratio. This is a simple calculation involving the amount of dividends distributed to shareholders divided by the net income of the company. What is not paid out to shareholders in the form of dividends is retained so the company may expand its operations (and possibly pay higher dividends in the future, when it stabilizes).
Not All Dividend Stocks Are Created Equally
There are many companies currently offering double-digit dividend yields, but this doesn’t mean they should be automatically dismissed as dividend traps and avoided at all costs. Furthermore, spooked investors who dump a stock in fear of impending dividend cuts could be missing out on valuable investment opportunities for two key reasons: 1) the stock price will decrease during a sell-off but could likely go back up in value over time, and 2) a company that hasn’t yet announced a dividend cut may not be planning one at all.
While it’s always good to approach your investment strategy with a healthy dose of skepticism, you don’t want to go overboard when reacting to whispers that a dividend might be cut in the near future. Some companies bounce right back after making cuts to their dividends, such as when Royal Caribbean Cruises cut their dividends down to 0.3% in December of 2011 (with share prices around $25) and bounced back to 2.3% dividend yields in June of 2018 (with share prices a little over $100). However, the goal is invest in companies that provide stable, growing dividends in both good and bad times.
Be Cautious with Dividend Traps
A suspected dividend trap don’t always mean you’re about to lose big on a particular stock, but it’s certainly worth your time to research the company more thoroughly and perhaps reallocate your investments to a more stable stock with comparatively lower dividend yields. The dividend payout ratio, debt to equity ratio and free cash flow can all be a great indicators of the company’s future decisions on its dividend policy, and even if a dividend ends up getting cut, this doesn’t mean it’s a permanent decision or won’t go back up after the company has recollected and revised its growth strategy. But, once again, the goal is to not suffer any dividend cuts.
There are no guarantees when it comes to dividend yielding stocks, but conducting research beforehand and striving for a balanced portfolio with minimal risks of dividend traps can help you earn the passive income you seek without leaving your portfolio vulnerable to volatile market conditions.