Is it possible to be blinded by dividends income and investment returns? Oh yes, and this is a common pitfall of being a smart investor. You may focus primarily, or even exclusively, on the dividend yield of a stock, but total income yield looks at the bigger picture. Here’s how to focus on total income and overall investment health instead of being blinded by dividend returns.
Dividends vs. Total Income Yield
If you’re a dividend investor, your primary concern in choosing any investment will be the dividend yield on the stock. You may set a yield threshold, a certain minimum rate of return on your investment. You’ll do this because you expect the primary return on a company will come in the form of quarterly dividends.
The basic philosophy behind a dividend strategy is the generation of income from your stock portfolio. It’s not that you’re not interested in capital gains, but rather that you are looking for income for immediate use. This could include using dividends to provide income during your retirement.
The idea is to collect the dividend income while allowing capital growth to increase your overall investment. In some respects, this is a perfect investment strategy.
Total income yield investors look at dividends, but only as a portion of the overall return on the stock. Capital gains will be at least as important as dividends, but the key is always the return from both the gains and the dividend yield.
While a dividend investor may look at a 3% dividend as his or her “income,” the total income yield type of investor will look at a 2% dividend yield, plus 8% capital appreciation over the past 12 months. In that regard, the total income will be 10%. If the total income yield investor sees this as an attractive rate of return, the stock will be purchased.
For the total income yield investor, dividend yield is never the primary criteria for buying a stock.
Why might total income yield investing be the better strategy?
Dividends Can Be Cut, Causing a Drop in Price
One of the problems with hyper-focusing on dividend yield is that yield isn’t necessarily permanent. Unlike the interest return on a bond or a certificate of deposit, there is no legal or contractual obligation for a company to pay a certain dividend level on its stock.
A $2-per-share dividend that produces a 4% yield can be cut in half if the company has a bad quarter or two or even if it makes a decision to change its future strategy in regard to the use of its profits.
When such an event occurs, not only is the dividend investor likely to see a drop in the company’s stock price, but it could be the beginning of long-term decline. After all, if a company has an above average dividend yield, it is likely the stock has attracted an unusual number of other dividend investors.
Once the dividend is cut, the stock will suddenly look less attractive, and those investors will bail out of the stock, causing the price to drop — sometimes significantly.
High Dividends Can Hurt Long-Term Prospects
The company has the option to invest its profits in several different ways, which can have a material effect on the future direction of the stock price. For example, the company could pay out some or most of the profits as dividends to shareholders.
Or it could invest in capital projects that are designed to increase revenues in the future. Or it may use much of the profit to buy back some of the company’s outstanding shares, which generally will have the effect of increasing the stock price.
If the company is paying out a disproportionate amount of its profits in dividends, it could have a negative effect on the overall growth of the company. If it’s a multi-year trend, the company may eventually find itself in a position of being less competitive within its industry. Eventually, revenues will decline and so will the stock price. At that point, the dividend itself will need to be reduced consistent with the company’s new economic situation.
In this way, investing in the stock of companies that pay excess dividend yields compared with competitors within their industry holds the very real prospect of investing in companies with below average growth prospects.
Think of this as the opportunity cost of chasing dividend yield.
Chasing Dividend Yield Can Leave You Over-Exposed
One of the problems with a dividend strategy is that all stock sectors don’t pay the same dividend yields. What is more likely is that select sectors will pay higher dividend yields than the general market.
This can leave you dangerously over-exposed to a very narrow number of investment sectors. And if one or more of those sectors falls on hard times, you could lose more money on your investments than the general market. It’s even possible you could lose money while the S&P is rising overall.
Let’s say you find plenty of high dividend stocks in the banking sector, so you load up on that industry. Conversely, you’ll likely find few high dividend stocks in the technology sector, as they tend to focus on growth. If you load up on the banking sector, you could miss greater capital gains in the technology sector.
Dividends Are Currently Low by Historic Standards
There is a particular risk to dividend investing in the current financial environment. The average dividend yield on the S&P 500 was 2.11% in 2015. Since 1960, dividend yields have floated between a low of 1.14% in 1999 and a high of 5.57% in 1981. Clearly we are now a good bit closer to the all-time dividend yield low than we are to the all-time high.
While dividend investing can make abundant sense when dividend yields are near all-time highs, the strategy may not work so well when yields are particularly low. In fact, in a low interest rate/low dividend yield environment, capital gains are usually more robust than either interest or dividend income.
By pursuing a dividend investing strategy now, you are essentially locking your portfolio into dividend yields that are very close to the bottom of market.
That can be a disaster if the next scenario plays out.
Sudden Increases in Interest Rates Are Dangerous
One of the inherent limitations with high dividend stocks is they tend to function in a fashion that is similar to long bonds. They have an inverse relationship with interest rates. Since the appeal of high dividend stocks is largely the dividend yield, the stock price will likely fall if rates on interest-bearing investments rise.
Let’s say you have a stock that is providing a 3% dividend yield at a time when the most you can get from a certificate of deposit is 1%. If the rate on the certificate of deposit rises to 5%, the 3% yield on your stock will no longer be very attractive. And since so many of the people who invest in the same stock are also investing for income, they may decide to bail out of the stock and move their money into certificates of deposit.
After all, not only is the yield higher on the certificate, but there is zero risk of loss of principal value.
The likelihood is the value of the stock will drop until the dividend yield rises to an effective rate of 5% or higher to match or exceed the certificate of deposit yield. This could result in a 40% decline in the value of the stock.
In the current economic environment, the likelihood of such a dramatic swing in interest rates is admittedly low. But were such a scenario to play out, it could be a disaster for dividend investors.
Are you a dividend investor, or do you prefer to focus on total income yield? Do any of the above risks influence your strategy?