investing and personal finance

Pitfalls to Dividend Investing

I am often weary of certain home-grown sites that preach dividend investing as the sure path to financial freedom. The basic premise of dividend investing is to seek out those companies that pay healthy dividends and have consistently grown those dividends over a long period of time. From that alone, it seems a solid approach as investors would be theoretically investing in growing companies that have the financial strength to continually grow their dividends AND by the investor focusing on the dividends (monthly, quarterly, yearly, etc), the focus on the short term is minimized and they tend to like price drops as it allows them to buy more shares of their favourite companies at cheaper prices and higher yields (essentially buy low and sell high). However, I see in many cases, the focus is on the monthly or quarterly dividends and nothing else, I never see any mention on the actual value of their investments, the main focus is only on the dividends received. As long as the dividends are there or increasing, they pay no heed to the actual value of their position. We should as investors focus on total return. Total return is the capital gains+dividend gains.

Not all sites are like this, there are quite a few solid ones. The following is from the http://www.thedividendguyblog.com and it does a solid job of describing the traps of dividend investing.

Dividend Investing is definitely one of the most popular and successful ways of investing. But it doesn’t mean that it works all the time. The whole point of dividend investing is obviously to get paid regardless what is happening in the markets. Some investors are so used to receiving their dividend distributions that they forgot they don’t own certificates of deposit and they are not receiving interest. Dividends are not 100% secured. In fact, dividend investing can also bring you big losses. There are some pitfalls you must avoid during your dividend investing journey:

#1 The High Dividend Yield Trap

If you have been following this blog for a while, you should have learned that the dividend yield should not be a factor in your investment process. Actually, as long as the dividend yield meets a minimum requirement (mine is set at 3%), you should not prefer a stock because it pays better than another one.

The high dividend yield trap is caused by greed. Investors are nostalgic from the time when we used to have Canadian Oil Income Trusts paying 8-9% with steady monthly distribution (anybody still hold ERF?). If you are still looking for high dividend paying stocks, you are heading towards the high dividend yield trap. This means that you buy the stock for its distribution. Unfortunately, there is a small print at the bottom of your trading slip: it says that the stock is unlikely going to continue paying its high dividend!

In the current market, there is one reason why a stock would pay higher than 5% in dividend; it’s because the dividend payout is not sustainable. If the market doesn’t think that the company will continue to pay its dividend, it starts selling the stock. The price goes down and the dividend yield goes up by default. If the dividend yield has increased significantly over the past 12 months and it’s not because the company is increasing its dividend, you are in a high yield dividend trap.

#2 The Being Paid To Wait Trap

We often hear about the good side of dividends during bear market as you are being paid to wait. We all know it’s not the right time to sell when the market is down. While your stock might take a 15% slump, you still earn your juicy dividend of 3-4%. This reduces your paper loss and encourages you to keep your stocks longer. But is the distribution enough to keep you waiting five years?

Pfizer (PFE) is a good example. Over the past 5 years, the stock has generated a big 1.66% investment return (dividend excluded) and over 10 years; we are at -17.91% (as at July 31st). Is the 3.64% dividend distribution enough to wait that long? It’s even worse in the case ofPFE since they cut their dividend back in 2009 during the financial crisis.

Closer to my portfolio, my recent experience with ZWB proves that the dividend yield is not enough to keep you waiting. After a year, I lost money on this trade while making a juicy 8% dividend yield. However, when I combined my dividend payout with the portfolio value, I was still at a loss. I sold ZWB and bought STX (Seagate Technology) instead. This is how I made by my money back in just three weeks. Will I continue to ride STX now that their latest results missed analysts estimate for the first time in 5 quarters? That is a pretty good question!

Because we buy dividend stocks for dividend growth.

Because we buy dividend stocks with a long term view.

Because we get paid quarterly for our patience.

Dividend investing also causes procrastination! We comfort ourselves as investors by thinking that we are not day traders and that we should buy solid companies paying steady dividends. This is why so many investors want to keep their investments for life. But the problem is that they keep the wrong stocks in their portfolio for too long.

Receiving a check every three months should never be a reason to keep a stock. Don’t become a lazy investor because you are watching your dividend yield more than you look at your portfolio value. You might be holding the wrong stocks that are vegetating around 1% growth while other companies are growing faster and still pay dividends. In order to not fall in the “being paid to wait trap” I suggest you reassess the reason why you bought your stocks on a yearly basis. If the reasons are not there anymore, there is only two options left; get stuck in the trap or sell!

#3 The High COP Dividend Trap

This third trap was brought up in a comment from Richard on “When Do You Sell When You Make Money?”. He mentioned that he keeps a few stocks paying very high dividends based on their cost of purchase (COP). If you do a good job with your stock selection, you will eventually get stocks paying 8% to 15% dividend yield based on your cost of purchase. In fact, the most courageous of you who bought Canadian Banks back in December 2008 are probably earning 25% dividend yield on theirCOP! This, unfortunately, is quite an exception.

More realistically, if you buy a company like Coca-Cola (KO) which historically doubles its dividend payout every 6.5 years, you will be earning a 7-8% yield in ten years. Then the catch is similar to the one found in the “being paid to wait” trap. Would you take your steady 8% dividend yield from a company that might only go down or would you restart with a fresh company paying a *small* 3% dividend yield but which is very promising? For the record, I’m not saying that KO should be sold because it’s going nowhere; I’m just taking the company as a good example.

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