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3 Reasons Why Investing in the Highest Dividend Yield Stocks Will Lose You Money

3 Reasons Why Investing in the Highest Dividend Yield Stocks Will Lose You Money

3 Reasons Why Investing in the Highest Dividend Yield Stocks Will Lose You Money

“I invest only in the highest dividend yield stocks”.

This is one of the most common phrases you’ll hear when you talk to income investors. While it makes sense to go for a high a yield as possible if you’re seeking dividends, the question is — do the highest dividend yield stocks make you a winner overtime?

Ned Davis Research conducted a study and divided companies into five different categories – S&P 500, non-dividend payers, dividend payers, dividend growers & initiators, and highest yield.

Ned Davis Research wanted to know the returns of investing $10,000 in each of these categories from 1971 to 2013. Here are the results:

Source: Ned Davis Research

Source: Ned Davis Research

Dividend growers & initiators gave the highest return; $10,000 invested would give you a cool $559,700 beating the S&P 500 index. And surprisingly, the highest yield stocks would have lost you money; $10,000 there would have given you less than half your money back. Ouch!

Why is this so?

The key to investing for income is not to invest in the highest yield stocks but to invest in stocks that pay sustainable dividends. And if you dig deeper, you’ll realize why the highest yield stocks underperform in the long run. Here are three reasons:

  1. Highest dividend yields are usually due to special dividends. The key to investing for dividends is sustainability. This means that a company must be able to pay stable or increasing dividends for a prolonged period of time. Companies which give special dividends create an illusion of extremely high yield, which will attract investors, but is not sustainable in the long run. Special dividends are one-time dividends and uninformed investors who jump in thinking the company can continue to pay such high dividends will be sorely disappointed.
  2. The company may be cyclical in nature. Companies that are cyclical in nature tend to perform better during the boom times. When these cyclical companies are performing, they tend to pay high dividends creating an illusion of very high dividend yields. When this happens, these cyclical companies are usually at the top of the cycle. Hence, investors invest in cyclical companies because of the high attractive yield without realizing the business and economic cycle of these companies. When the cycle eventually goes down, these investors end up losing when stock prices fall and their dividends inevitably get cut.
  3. Highest yields are caused by depressed stock prices. Companies that have the highest yield may be due to depressed share prices. In many cases, a depressed share price could be due to a company’s weakening fundamentals and business model. If it continues and the company’s business environment gets more competitive, revenues and profits will fall, and investors will eventually see their dividends cut. Even though you might still receive your dividends every year (and falling), it is unable to compensate for the loss in stock prices as the company’s fundamentals continue to weaken.

Conclusion

When looking for dividend stocks to invest in, always focus on the sustainability of dividends rather than highest yield alone. Always remember to exclude special dividends and avoid investing in cyclical companies for dividends. Ultimately, if you want to enjoy long-term growing dividends, you need to pick a company that has strong fundamentals and a superior business model that allows the company to grow its revenues and profits for many years to come.

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Robin Han
Victor Chng

Victor Chng is an equity investor and the co-founder of the online investment magazine The Fifth Person. He is also the co-creator of The Investment Quadrant, an online multimedia stock investment course where students can learn how to invest profitably in the stock market. Victor has been featured multiple times on 938LIVE as a guest expert on MoneyWise and is also the co-author of Value Investing in Growth Companies which is internationally published by Wiley, Inc. The book can be found in all major book stores worldwide and on Amazon.com, Amazon.co.uk, Barnes & Noble and Apple's iBooks. If you're interested to learn more about stock investing, you can join The Fifth Person Newsletter and receive free weekly insights on how you can generate higher returns and dividend income from the stock market.