Dividend income plays an important role in building wealth, but investors who chase yields offered by dividend stocks may be taking on more risk than they realize.
Almost all Millionaire investors receive dividend income and expect dividends to provide up to one-third of their income in retirement, according to a December survey by Millionaire Corner. Of millionaires with a net worth of $10 million to $15 million, 98 percent receive dividend income. The pre-tax average for 2009 was $200,000.
Dividend stocks offer many advantages. They give investors a share of company profits, and the regular cash payments provide income and eliminate some investment uncertainty. Reinvested dividends allow investors to accumulate shares without draining money from other parts of a portfolio.
Dividend income is especially tempting with current low-interest rates, but investors who gobble up dividend stocks may be putting too much of their portfolio at risk. Dividend-yielding stocks tend to fare better than growth stocks in a down or turbulent market, but they are still riskier than many fixed-income products.
A look at Walmart or Johnson & Johnson shows that shares of trusted dividend stocks can and do fall in price. What’s more, a company’s Board of Directors can slash or halt dividend payments in hard times. To make matters worse, a dividend cut is usually followed by a drop in share price. Dividend income, typically paid quarterly, is also taxable.
Investors who chose to seek dividend income despite the risks are wise to look before they leap. Thorough research can help an investor chose an undervalued company in a strong financial position. The company’s price-to-earnings ratio is one indicator of whether a company is under or over valued. Investors should also analyze the company’s ability to continue paying dividends while meeting all its other financial obligations. A company in a declining industry sector may be in a weaker position than a company in a growing sector.
Some advisors recommend examining the dividend-paying history of a company, though past performance is no guarantee of future results. Companies with a stated dividend policy can give investors of better feeling for the board’s commitment to maintaining dividend payments. Investors choosing dividend stocks should also follow commonly accepted guidelines for buying equities of any type.
“When you buy a stock, you’re buying part ownership of a company, so the questions to ask as you select among the stocks you’re considering are the same questions you’d ask if you were buying the whole company,” said the Financial Industry Regulatory Authority, a self-governing group. FINRA advises investors to evaluate a company’s products and whether the goods or services are in demand. The quality of company leaders, the size of its debt and its operating costs are all important criteria, said FINRA, whether you’re seeking dividend income or capital gains through share price appreciation.