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Chasing Dividends...Buyer Beware

Updated on May 7, 2014

Finding Income

One of the most common mistakes of investors is to select investments exclusively on the basis of historical track record without a forward looking forecast. Even more common as of recent is to look at the dividend yield of a security and utilize this as sole method for purchasing an investment. Part of the reason for this resides in the fact that we live in a period that presents us with a historically low interest rate environment. The low rates offered on savings, CD’s and various other fixed income investments can present investors in need of cash flow with limited options and send them searching for cash flow in riskier investments like stocks. While most long term investment portfolios should have a component that encompasses stock market exposure, the potential for cash flow should not drive one from conservative investments to risky assets on that basis alone.

What’s wrong with dividends ??? The answer is generally nothing. Dividend yield can be attractive. But keep in mind that when a stock dividend’s yield has increased, that is not always reflective of an increase in the payout of profits. At times a stock may have simply declined in principal value, therefore making the annual dividend a higher overall yield at the current stock price. While the lower price of the security may be attractive, it is not always the case. These could be reflective of a serious problem in the company or industry. Have the fundamentals or long term business prospects of the company changed that could have affected the price of the security ??? If so, will the stock decline further. If you’re evaluating the specific security these things are important. You need to look closely at things like the Free Cash Flow of the company to better understand whether or not the ability to continue to pay that yield is feasible. In the early stages of the financial crisis of 2008/2009 there were a number of financial institutions such a Citigroup that paid dividend yields of in excess of 7%. Yet the return of your principal was not to be realized anytime soon, and in some cases never.

When measuring the overall rate of return of dividend paying stocks versus those that do not typically pay sizeable dividends, essentially you are analyzing value investing versus growth investing. While it is true that value stocks have somewhat outperformed growth securities over the longer term, this has not been the case when examining the more recent history. If your goal is to accumulate wealth, isolating one area of the market is never a good idea since you cannot be sure of the shorter term trend.

What about those using dividends as a means of required cash flow ??? In reality, higher dividend stocks or stock funds will likely compromise some part of your investment plan. But NO stock or stock fund is a substitute for a fixed income instrument. If you buy a stock for a 5% dividend yield and the stock declines by a factor of 20%, you would have simply been better of spending down 5% from your savings account with a meager interest rate. It is important to understand that the single biggest factor impacting those investors who are dependent on their portfolios for income is not the dividend yield, but rather the sequence of their investment returns. The impact if a negative sequence on your investment distributions can be financially catastrophic to your portfolio and retirement planning strategy. For a greater understanding of the risks surrounding a negative sequence in your investment portfolio see the below link.

http://landmarkwealth.hubpages.com/hub/The-Impact-of-Distributions-in-Volatile-Markets

This does not mean that you should abandon risk based assets altogether. It simply means that you should purchase an asset for what it actually is. Unfortunately in recent years, the Federal Reserve’s ZERO interest rate policy has by design driven many investors into riskier assets for the wrong reasons. A stock or stock fund is not a substitute for a conservative investment. If you are buying a stock, then look beyond the dividend yield at what kind of business you are actually investing in. Look at all aspects of the investment itself and not just the high upfront payout. Even in the current interest rate environment, fixed income markets have actually had comparable and in some cases better returns to stocks over the last few years. This is due to the price sensitivity to global factors as well as interest rate changes and at times a negative correlation to stock market volatility.

If you’re goal is to draw an income from an investment portfolio, there are numerous parameters that should be followed. Yet the most basic aspect is to build an overall asset allocation that is consistent with your cash flow objective. Due to the cyclical nature of different asset classes, drawing an income stream proportionately across the portfolio tends to have the highest probability of success. For a better understanding of asset allocation and its impact on volatility read the below link.

http://landmarkwealth.hubpages.com/hub/The-Importance-of-Asset-Allocation

Lastly, keep in mind that when designing an income plan, each situation is unique. Various things such as age or age disparity between spouses can and should have a great impact on the decisions you make with your investments today and into the future.


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