FAQ: Now that I’m retired, what do you think if I invest in only high dividend stocks for the income they provide?
Answer: This is a question we get from time to time that can be very concerning. Anytime investors put most or all of their investments in one asset class, they are setting themselves up for problems, however, more than that, the nature of this question typically means that the person asking is unaware of the risks associated with this strategy.
Anytime you put your hard-earned money to work for you to go out into the world and multiply, you are taking risk. Risks that are easy for investors to understand are market risk, the risk that my investment fluctuates in value, and default risk, the risk of whatever I invest in going belly up and losing my entire investment.
However, there are several unseen risks that are not always so apparent to investors. A good example of this is inflation risk. This is the risk that costs to purchase goods are going up quicker than the value of my investment. Thus, even though my investment appears safe and I will get what I invest plus some interest, the money returned to me will be less valuable than when I lent it out (i.e. it can buy less goods), even though the absolute value is more. This is a risk that is far less perceptible to investors than market fluctuations, but it can have just as terrible consequences if not properly managed.
In the case of high dividend paying stocks, there are several less than transparent risks. The one any investor needs to be on the lookout for is a common investing error called a “dividend trap”. A “dividend trap” can occur when a company that pays a sizable dividend begins to see its stock price fall due to a systematic problem in its industry or poor management. As the stock price falls, the dividend yield (which is calculated by dividing the dividend paid in the past year by the stock price) can increase dramatically, making it look like a compelling investment. However, the fundamental problems with the underlying business mean the company will almost certainly cut the dividend in the future and possibly even go out of business.
(For example: General Motors is a $100 stock that pays a $6 (6%) annual dividend. However, the car business is in trouble and the company stock falls from $100 to $20 in three months. That 6% yield is now a whopping 30%. It may look like a fantastic dividend paying stock, but the company is a shaky investment and will most likely cut this dividend in the near future. In the case of General Motors, they actually filed for bankruptcy in 2009. You would have lost 99% of your invested funds stretching for high dividends).
The most important lesson in investing is understand the seen and unseen risks of your investments. Reaching for yield through dividend stocks can be a good part of a diversified portfolio, but as with almost all investment strategies, should be diversified. Diversification is the best way to manage all the risks you will face in your investing life.