Avoiding the Dividend Trap

Dividend-paying stocks are often seen as being higher-quality and stabler than their non-dividend-paying counterparts. Thus, they can be viewed as the next step up on the risk/return spectrum between lower-risk bonds and higher-risk stocks. But there is a point at which dividend-paying stocks actually become riskier than the average stock. Dividends have historically accounted for 40% of the returns from investing in stocks, and despite conventional wisdom, high-dividend-payout companies tend to have stronger earnings growth. So the case for investing in companies that pay dividends is a strong one.

It seems that a logical way to achieve a high yield on a dividend fund would be to weight stocks by their dividend yield, so that high-yielding stocks would make up a larger percentage of the fund. But unfortunately, it does not follow that if dividends are good, a higher dividend yield must be better. The fact is that this approach does nothing to screen out the low-quality, risky companies that are likely to cut their dividends in the future, or even file for bankruptcy.

Source: Morningstar

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