Top 4 Reasons to Not Chase Dividend Yields
When it comes to dividend investing, you may be tempted by the potential offered by high dividend yields. It makes sense, as maximizing your gains can help you reach your financial goals quicker (can you say retire early?) High yields are attractive but chasing them could be asking for trouble. Here are the top 4 reasons to not chase dividend yields.
Income
Reason #1: Overvaluation
Stock prices rise for a variety of reasons, often it's based on the whims of investors. How many times have you seen stocks skyrocket, only to come back down to earth after the hype cycle is complete?
When a dividend stock becomes overvalued, the yields drop. Companies simply cannot sustain paying the same level of yield for a $300 stock as they can for a $20 stock, which will disappoint dividend investors who will gladly chase the yields of another company paying a higher rate.
Reason #2: Poor Diversification
Certain industries are known for paying out dividends. There aren't that many industries that pay a high yield consistently. Utility companies, REITs, BDCs, and a few others are among companies that pay these high yields. If you are a yield chaser, you limit the number of industries that you have available for your selections.
Rising Stock Chart
Reason #3: Opportunity Cost
When you were a kid, you likely had a limited allowance. When you went with your friends to the candy store, you have several choices of candy to choose from, but limited funds. When you buy one type of candy, you will not have enough money to buy another type. But what if you choose a new one that you don't like? You'll now have to wait until the next allowance payout to buy the better choice.
Vintage balance scale
This type of scenario highlights what is meant by opportunity cost. In this scenario, that cost is having to wait until the next pay cycle to get the better candy bar. With investing, if you pay out a good chunk of your funds as dividends, you won't have the necessary funds you need to invest in more substantial assets that have the potential for growing your business. Yield chasers will be happy but investors looking for a sustainable future will likely experience disappointment in the long run.
Reason #4: High Yields Could be a Sign of Trouble for the Company
When a company begins to struggle financially, they sometimes will entice investors with a high yield payout with the hope of keeping investors from jumping ship. It's not effective, though, as investors will eventually discover the deception. The sell-off is likely to be even bigger when this occurs.
Decline crisis concept
Hopefully, this article has convinced you that there is more to the yield when investing in stocks paying dividends. A better approach is to look for companies that have consistently raised their dividend year after year. All equal, these are usually companies that have solid fundamentals, otherwise, how could they get away with increasing the dividend for many years? It is a good idea though, to check into the company's financials, even if they have a good track record of dividend increases. You can never be too careful, and the information is easy to find, either on the company's investor page or from the SEC.
Conclusion
In summary, if you are lured by high dividends, take a step back and evaluate the motivations for these strong yield payouts. More often, they will indicate scenarios that are too good to be true, or they will lead you astray in your overall investment goals. Focus instead on finding solid companies with a history dividend increases.
