There has never been a better time to start investing in dividend paying stocks. These versatile investments provide investors a powerful combination of fixed income and future growth potential. Furthermore, adding a handful of stocks that pay dividends can greatly reduce a portfolio’s overall risk. While it is certainly true that dividend paying stocks are generally considered a crucial element to a well balanced investment plan, there are a few things you need to carefully consider before investing any of your hard earned money.
You would be hard pressed to find a certified financial planner that does not advocate the importance of diversification to his or her clients. Just about every investor has heard the phrase, ‘don’t put your eggs in one basket’. Despite the fact that dividend investors are generally considered to be rather conservative, many times the choices these individuals make actually exposes them to greater risk when compared to other, more traditional investors.
Dividend Paying Stocks
When searching for stocks with the highest dividends, it is easy to be distracted by the overall yield. Many times a high yield can simply be the result of a stock that is falling in value. Additionally, many companies pay dividends in excess of the company’s current earnings; which is never a good sign.
Perhaps even more troublesome is the fact that stocks with the highest dividend yields often come from one industry or market sector. If, for example, an investor invests in a number of companies in one or two industries, their portfolio is at greater risk should that industry fall out of favor. To make matters worse, when a company’s stock price is rapidly declining, many times the company’s directors will actually cut their quarterly dividends; making a poorly performing investment even worse.
To avoid this issue, many investors have jumped on the ETF bandwagon. These investors are under the erroneous belief that all dividend ETFs are well diversified, when in reality, these indexes are often weighted more heavily towards higher dividend paying stocks. Many sectors, such as utilities, are given ten times as much weighing as health care or technology stocks. Of course, this makes perfect sense as the stated goal of any managed fund, including index funds, is to attract additional investors.
Savvy investors would do well to ensure that their portfolio remains well diversified across a number of distinct market sectors. Doing so will help reduce the hidden, yet potentially devastating, risk of dividend paying stocks.