Avoid the Dividend Trap

Dividend-paying stocks are often seen as being higher-quality and more stable than their non-dividend-paying counterparts. For income-orientated investors, they are viewed as the next step up on the risk/return spectrum between lower-risk bonds and higher-risk growth stocks. But there is a point at which dividend-paying stocks actually become riskier than the average stock. Just after last year's Gulf oil spill, shares of BP (BP) offered a trailing-12-month dividend yield of 9%.

This would have been a great deal if it was sustainable, after all ExxonMobil's (XOM) yield is less than 3%. But the market was correctly forecasting that BP's dividend would be cut. Another example is New Century Financial, a subprime mortgage REIT that offered a dividend yield of around 18% at the peak of the housing bubble. That high dividend was nothing more than a trap, as the firm filed for bankruptcy when the housing bubble burst.

Source: Morningstar

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