Alert: Be Careful of this Investment Strategy

The stock market has certainly had a bumpy ride over the last few years.  The instability of the market has created a large number of questions for the individual investor. One question that I have been asked by many involves stock dividends. The question goes something like this:

If money market and CD rates are paying laughable returns, why not invest in solid dividend paying stocks to get a better return on investment?

In a perfect world, it would be great to buy a stock and use the dividend paying ability of the stock to shore up income needs. But, we don’t live in a perfect world, and, unfortunately, the dividend approach does involve risk.

Let’s first review how a stock’s dividend works.  If someone owns 100 shares of XYZ stock that is trading at $100 a share, the value of the stock is worth $10,000.00. If the stock pays a dividend of $3 a share, the stock’s dividend yield is 3%. So, this scenario would produce a total dividend pay-out of $300.

The arguable theory is that 3% is much better than the lousy money market rates out there in today’s market. Investing $10,000 in a stock yielding 3% seems like a better way to capture a decent return, right? Why not buy a stock like Johnson and Johnson? Again, this sounds great in a perfect world, but remember we don’t live in a perfect world.

Let’s look at Johnson and Johnson, which is usually thought of as a solid stock. J&J has a nice yield of roughly 3.5%. Buy $10,000 of J&J and the 3.5% yield produces a nice little return. If an investor bought J&J in Mid July this summer, the price was hovering around $67 a share.  Move ahead to mid August and the price of the stock falls to almost $60. That produces an unrealized loss of over 10%. As of this writing, the stock is trading at close $64 a share…still a 4.5% loss.  The 3.5% yield doesn’t outweigh the 4.5% unrealized loss. This dividend strategy involves risk to the principle, which is not a risk involved ( or should not be involved) in the principle invested in money markets or CDs.

Some try to argue that the loss is simply a paper loss. This may be true, but it’s important to understand how this paper loss impacts the total portfolio. Most importantly, the asset that was once held in a safe, stable account (money market) is now put at risk.  By investing in an individual stock the total risk of the portfolio changes.

Risk should be focused. Most often the assets the investor would use for this dividend strategy are assets that are held for liquidity (emergency funds). Again, this changes the portfolio’s risk and may endanger the investor.

Three reasons why I don’t like this dividend strategy

  1. The total value (principle) of the asset (Stock) is at risk. While the stock yield may outperform comparable interest rates, the total value of the stock is at risk to decline, as seen in the J&J example.
  2. The company can change or stop the dividend.  There is no guarantee the company will continue to pay the dividend moving forward.
  3. Individual stocks are much riskier than mutual funds. Due to the nature of an individual holding, the company’s stock could see wild swings based on the company’s performance.

The dividend yield idea may seem like a great idea on paper, but it’s important to take a closer look at the true risk involved with this sort of plan. Safety trumps yield when it comes to stability and the safety of our cash.  Investing should be done in a methodical approach. Simply chasing yield may produce a result not intended.  Focusing risk in the areas of the portfolio where risk should be held is appropriate. Areas of the portfolio which should contain little risk, such as emergency funds, should be held in stable investments, such as money market accounts. 

 DISCLAIMER: This publication is not a substitute for your common sense or for the guidance of your accountant, financial advisor, lawyer, or any other personal or professional advisor. It is designed to provide accurate and authoritative information, but neither the author nor the publisher renders any professional service (legal, accounting, investment advice, or any other professional service) to the reader through this publication. If you need expert advice for your situation, seek out and use the services of a competent, knowledgeable professional. Note that laws and rules applicable to your situation may change and may differ from those described in this publication. It is your responsibility to seek further professional guidance whenever necessary. The author, publisher, and seller jointly and severally disclaim any warranty, express or implied, for any general or particular purpose, including any warranty of merchantability. The reader should be aware that some of the information provided herein is subject to change without notice. It is the reader’s responsibility to determine whether updated information is needed.

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