Dividend stocks have been highly fashionable for about five years, as stock market volatility has shaken investor confidence and as rock-bottom rates at the U.S. Federal Reserve have slashed yields across the board.
But there is a fundamental misunderstanding among investors that dividend stocks are inherently safe.
They are not.
Here are three big risks in dividend stocks that most investors either aren’t aware of, or that they are simply ignoring at their own peril:
Low Volatility Works Both Ways: Last year, the stock market went like gangbusters with 30% gains for the major indices. However, dividend stock funds such as Vanguard Dividend Appreciation ETF (VIG) or the T. Rowe Price Dividend Growth Fund (PRDGX) only were up about 25%. Tom Huber, portfolio manager for the T. Rowe fund, explains why: “You should outperform in choppier, lower-return markets, but you’re not as likely to participate fully on the upside in strong markets.”
Low Volatility Is Not Low Risk: Even worse than broad-based dividend funds has been the performance of the Utilities SPDR (XLU), an ETF that focuses wholly on dividend stocks in the utility sector. In 2013, the fund was up a measly 13% including dividends vs. the 32% gain for the broader stock market — and one of the biggest dividends stocks out there, utility leader Southern Company (SO), barely finished flat, and that’s including its hefty dividend. There is no such thing as a “risk-free” investment, and even low volatility dividend stocks carry their own flavor of risk.
High Dividend Is Not Always High Return: There’s an old joke among investors who chase yield: The easiest way for a stock to see its dividend yield double is to watch its share price get cut in half overnight. Take retailer Coach (COH), a big consumer brand with a big dividend yield of 3.3% … and a 12-month performance of -30%. Or oil services stock Transocean (RIG), which yields more than 7% but has lost about 17% since January alone.
Many investors falsely believe that a big yield in their dividend stocks is a guarantee of stability and a decent annual return.
But sometimes high-yield dividend stocks underperform, and sometimes even a big dividend yield isn’t enough to offset the steep declines in share prices.
Remember, there is no such thing as a risk-free income strategy. Even in AAA bonds, you shoulder risk — of missing out on other opportunities.
So, always assess your risks accordingly and realistically.
Jeff Reeves is the editor of InvestorPlace.com and the author of The Frugal Investor’s Guide to Finding Great Stocks. As of this writing, he did not hold a position in any of the aforementioned securities. Write him at firstname.lastname@example.org or follow him on Twitter via@JeffReevesIP.