Pitfalls of High Dividend Stock Investing

By on December 7, 2010

Larry Swedroe, author of numerous investing books, points out that investing in stocks paying high dividends is no substitute for a good fixed income strategy or a diversified stock approach.

While the financial media touts high-dividend stocks strategies as alternatives to other prudent investment strategies — such as equity strategies or high-quality fixed income portfolios — there are several issues you should consider. First, a high-dividend strategy is far riskier than a high-quality fixed income approach, so comparing the two is like comparing apples to oranges.

Second, a high-dividend strategy is essentially a value stock strategy, which involves buying companies that have low prices relative to earnings, book value, dividends or some other accounting metric. However, the high-dividend approach to a value stock strategy has historically had the lowest returns, and returns (meaning dividend payments plus capital appreciation) are ultimately what should matter.

Swedroe goes on to show that using the high dividend approach for investing in value stocks is a poor substitute in producing risk adjusted returns compared to three other strategies over the period 1952-2009; 1) low price to book value, 2) low price to earnings, and 3) low price to cash flow.

SMA Comment:  Dividend paying stocks have been popularized in the media over the past couple of years.  This is partly due to the low interest rates available on certificates of deposit and money market funds.  Anytime something becomes as popular as dividend-paying stocks seem to be right now, investors should be wary.  However, there are a substantial number of stable companies that pay a modest dividend that will probably never be cut and will likely increase over time.  This is where investors should concentrate when looking for alternatives in this area.  Several attractive stocks with above average yields currently are Abbott Labs (ABT), Clorox (CLX) and Lilly (LLY).

Source: Moneywatch
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