In this post, we will discuss the risks of pursuing a high dividend yield, but first, here is our disclosure.
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Too much of a Good Thing is a Bad Thing
Dividends are one of the greatest parts of investing. There is nothing quite like the feeling you get when a company pays you money for simply owning its stock. Think about it. You get to share in a company’s profit all because you decided to buy shares in it. There is no work required other than research and making the purchase. How awesome is that?
But beware!
Too much of a good thing is a bad thing.
Dividends are no exception to this rule. Buying a stock or security based solely on dividend yield can be a recipe for disaster. When it comes to dividends, there is a direct correlation between risk and reward. In most cases, the higher the dividend yield, the greater the risk. The reason is a high dividend yield is often a result of financial troubles.
Also, you may be sacrificing growth over income by chasing dividend yield. Growth companies offer lower dividends or no dividends at all. Instead, they put the majority of their profits back into their business. This leads to the potential for faster stock price increases.
How do I know so much about the risks and drawbacks of chasing high dividend yields?
It is because I have been there and done that. I know it seems easy. All you have to do is buy stocks with the highest yield. Right? Wrong.
My results have not been pretty. Most of my picks have been downright awful. The reality is that picking individual stocks is very hard to do and involves a great deal of risk. Choosing the right high-yield dividend stock might be the most challenging pick of them all.
Let’s start by understanding dividends before discussing my failures.
What are dividends?
Dividends are a portion of a company’s profits that it distributes to its shareholders. They are usually paid in cash or stock and are a way for companies to reward their investors. Dividends can be paid on a regular basis. The most common practice is to distribute them quarterly. However, some companies distribute dividends monthly, yearly, or as a one-time payment.
The dividend amount can vary depending on the company’s financial performance. If a company is doing well, it can increase its dividend payout. When a company struggles, it can cut or even suspend the dividend.
Not all companies pay dividends. Many choose to reinvest their profits into the business to grow the company. Some companies may use a portion of their profits on stock buybacks. In both cases, the goal is to increase shareholder value through a rising stock price.
Other companies are required by law to return most of their taxable income to shareholders. These companies tend to fall under two major categories. The first is Real Estate Investment Trusts or REITs, and the other is Master Limited Partnerships or MLPs. You will find some of the highest dividend yields under these two business types,
What is Dividend Yield?
The dividend yield is the ratio of a company’s annual dividend per share to its current stock price. Calculating dividend yield is easy.
You calculate dividend yield by dividing a company’s annual dividend per share by its current stock price. It is that simple. The key concept is that if a company’s stock price increases, the dividend yield decreases and vice versa. Let’s see an example of how stock price impacts dividend yield.
Super Corp and Their Dividend
Suppose we have a company, Super Corp, with a stock price of $50 and an annual dividend of $1 per share. The dividend yield for Super Corp is 2% ($1/$50 = 0.02 or 2%).
Imagine Super Corp is having a great start to the year, and its stock price has increased to $100 per share. This increase reduces the dividend yield to 1% ($1/$100 = 0.01 or 1%). You are still getting the same $1 per share, except it is now a smaller percentage of Super Corp’s stock price.
During the second half of the year, Super Corp finds its business slowing and reports horrible financial numbers. As a result, its stock price plummets to $25 per share. What happens to the dividend yield? It skyrockets to 4% ($1/$25 = 0.04 or 4%). Once again, you are still getting that same $1 per share dividend, except now it is a larger percentage of Super Corp’s stock price.
However, Super Corp can no longer sustain its $1 per share dividend due to its slowing business. So, at the next board meeting, Super Corp decides to cut its dividend in half to $0.50 per share. This results in a new dividend yield of 2% ($0.5/$25 = 0.02 or 2%).
If you want to learn more about dividends, check out this article on dividends at Investopedia.
Now on to my mistakes!
My Biggest Dividend Yield Mistakes
My biggest dividend yield mistake has been investing in the ultra-risky world of mortgage REITs. In 2022 I bought shares of Annaly Capital Management, Inc.(NYSE: NLY), AGNC Investment Corp (NASDAQ: AGNC), and RC Capital Corp (NYSE: RC) to take advantage of their high dividend yields.
To say mortgage REITs or mREITs, are risky is an understatement. I invested in mREITs because I was chasing yield, and many mREITs have double-digit dividend yields. It was just too hard to resist dividends exceeding 10% when inflation was raging. To make things even more tempting, several mREITs have a monthly dividend. I had to give mortgage REITs a try.
The problem with mortgage REITs is that they hold a lot of debt. So higher inflation leads to higher interest rates, which leads to higher borrowing costs. The result is lower profits for mREITs.
So why did I decide to buy mortgage REITs?
I made the decision to buy mortgage REITs in 2022, hoping to get in while mREIT stock prices were low due to higher inflation. I believed I was getting them at a discount while receiving a double-digit dividend yield. My plan was to add to my shares by reinvesting the dividends. Then when market conditions improved for mREITs, I would be sitting on a gold mine.
That was wishful thinking and a stupid reason to invest in such risky companies. Since then, it has been all downhill.
All three mREITs are trailing the S&P 500 despite having dividend yields near or above 10%. I have been reinvesting the dividends into the three mREITS to increase my returns. Yet, they still have negative returns over the past year, whereas the S&P 500 is in positive territory.
Why Reinvest Dividends?
Reinvesting dividends helps to boost your returns because the shares you add are at zero cost. By reinvesting dividends, you are adding shares while lowering your cost basis. Also, the shares you add will go on to earn dividends, increasing the total size of the dividend payout. So, reinvesting dividends might be a good option if you do not need income immediately.
However, always remember the dividend is only as secure as the company paying them. If a company falls on hard times, it may cut or even suspend the dividend. This means even after reinvesting all the dividends, down the road, you may have no income to show for it when you need it most. So be careful with your choice of dividend-paying companies.
Raw Returns
I want to say the worse is behind me with my investments in Annaly Capital, AGNC, and RC Capital, but I do not see a lot of sunshine ahead. If you look at the raw returns, excluding dividends, all three mortgage REITs have poor track records. I know past returns do not guarantee future returns, but they are downright miserable.
For instance, Annaly Capital is down over 50% over the past five years. What about the S&P 500? It is up over 50% during that same period. The results are almost identical for AGNC and RC Capital. There will never be enough dividends to compensate for such a tremendous loss. In my opinion, there are better options that can offer both dividends and returns without the high risks of mREITs.
Alternative Investments for Dividend Yield
If you want to earn dividends without taking on high levels of risk, there are many alternatives to companies offering sky-high dividend yields. Below, I cover a few of these alternatives.
Dividend Kings and Aristocrats
Dividend Kings are companies that have paid and increased their dividends for 50 consecutive years or more. Aristocrats are companies that have done it for at least 25 years. These include some of the most well-known household names like Coca-Cola and Walmart.
Dividend kings and aristocrats are not going to give you double-digit yields. Instead, you will receive stable dividend yields in the single digits. Don’t let that fool you. These are companies that have grown their dividends for over 25 and 50 years. In order to do that, they need to be able to grow their business and increase their stock price.
Dividend ETFs
Picking individual stocks can be risky, no matter if they are dividend kings or not. A better alternative might be investing in low-cost ETFs specializing in dividend-paying companies. This strategy will allow you to reap the benefits of dividends and diversification through one fund.
Much like dividend kings and aristocrats, your dividend yield from these ETFs will not reach double digits. That is OK. The reduction in risk more than makes up for the reduction in dividend yield.
Traditional REITs
Traditional REITs invest directly in real estate. They derive their income from owning and operating properties. They are a great alternative as they allow you to invest in real estate without the need to own property. In turn, many offer stable and reliable dividends.
S&P 500
A low-cost S&P 500 index fund, or ETF, might be the single greatest wealth-building tool on the planet Earth. If you are interested in investing in stocks, there might not be a better place to invest. An S&P 500 index fund or ETF provides instant diversification across 500 of the largest publicly traded companies in the US. These funds also offer a dividend yield usually around 1.5% to 2%.
The S&P 500 index fund or ETF may not have a high dividend yield, but it offers a unique blend of large-cap value and growth companies. The dividend is just icing on the cake.
Key Lessons from Chasing Dividend Yield
Make a Plan
The first rule of investing is to determine your goals and create a plan that meets those goals. Having a plan is crucial when investing in risky companies like mortgage REITs. Looking back on it now, my plan stunk. “I will give it a try” is not a plan. In other words, I was throwing mud at the wall to see what sticks. That is not a good plan to follow when investing.
At the time, I thought I had a good plan. That was not the case, but hindsight is always 20/20.
To make matters worse, I did not have a clear idea of what I wanted from the investments. Was it income, or was it stock price returns? Instead, I took a middle-of-the-road approach by reinvesting the dividends. This would bolster my returns now while increasing my dividend income later. The problem is I did not define what “later” meant.
Will I start taking the dividends as income in one year, five years, or at retirement? If I was only going to hold these stocks for a few years, I should have never invested in mortgage REITs. On the flip side, if I am going to keep these investments for the long term, there are many better options.
I can see now that I boxed myself into a corner. All because I did not have a plan.
Don’t be like me. Never invest for the sake of investing. Do not let your investments determine your goals. Instead, assess your investment goals and build a plan. Then select investments that fit your plan that help you achieve your goals.
Invest. Do Not Gamble
I did not have a good plan, but I was saved by the one rule I always follow:
Investing is not gambling. If you do decide to gamble on a stock, never bet more than you can afford to lose.
I did not throw a ton of money at mortgage REITs. They are very high-risk, so I knew I was gambling, not investing. So I made sure to limit my exposure.
Always remember that stock picking is risky. Do not gamble your future away. This is why I keep individual stocks to 10% or less of my investment portfolio. This allows me to take a chance on a stock without destroying my financial future.
It is alright to take small chances but don’t get caught up in get-rich-quick stocks. Your goal is financial freedom. It takes time and a plan to reach that goal. Remember, when you gamble, the odds are against you.
Where To Now With Dividend Yield?
There is no doubt I took a considerable risk chasing dividend yield. Even after reinvesting the dividends, all three mREITs are still trailing the S&P 500 by wide margins. Yet, I am still holding onto all three investments. They account for a tiny percentage of my portfolio, so I have minimized their risk to my returns.
So, even though I view my investment in mREITs as a mistake, I am not selling quite yet. Instead, I am now doing what I should have done at the beginning and making a plan. That plan starts with an exit strategy.
Exit Strategy
When I decided to invest in high-yield mortgage REITs, I knew it wasn’t the best time. Mortgage REITs are highly leveraged, and inflation was running at a 40-year high. To make things worse, the Fed was jacking up interest rates while dumping off mortgage-backed securities. This was a perfect storm, and I was willing to jump in while mortgage REITs were way down.
Things are starting to change. Inflation has cooled and is getting close to the Fed target of 2%. Also, the Fed has signaled that interest rate hikes may end soon. The big drag that remains is housing values and mortgage rates. Those are not coming down, and they have a direct impact on mREITs. There is also the big question about the economy. Will it continue to chug along, or will it start to cool off?
So, I plan to give it one more year to see how all this craziness with interest and mortgage rates shakes out. By then, I will better understand where things are heading with mortgage REITs and their dividend yields.
The key point is that my stake in mortgage REITs is tiny, so I can stay at the table gambling a little longer. Odds are, at some point, I will cash out at a loss. That is the reality when you chase dividend yield.
Dividend Yield: Adding it All Up
Chasing high dividend yields can be risky. While they may seem attractive at first, they can be the result of a sharp drop in stock price, causing the yield to rise. This could be a sign of financial trouble or market skepticism about the company’s future prospects.
Also, some companies may inflate their dividend yields to attract investors. As a result, they may not have the earnings to support those payouts. So, it is important to analyze a company’s fundamentals before investing. Do not rely only on the dividend yield when making a choice.
Consult a professional when unsure about what’s best for your financial situation.
Until next time, good luck on your money journey.
