The Motley Fool

Seduced by High Dividend Yields? Don’t Be

Dividend investing is an amazing process – you purchase shares of a company which then give out regular streams of cash which flow into your pocket over time. However, as with anything in life, chasing after too much of a good thing may end up being harmful.

While dividends do excite investors, they have to be wary of companies that seem to be paying a dividend yield which is much higher than the norm. So let’s break down why investors should be cautious about high yields.

Don’t go chasing high yields

Investors need to observe the average dividend yield of a basket of similar stocks within the same industry. This provides a great benchmark as to how high a yield one can reasonably expect to obtain. A good example would be the real estate investment trust (REIT) sector – the average dividend yield of a basket of REITs range from 5% to 7%, depending on the type of properties held, country exposure and risk level.

An investor who then decides to select a REIT with a higher-than-average dividend yield (for instance, 9%), should then be aware that the risks may also be proportionately higher as a result. High yields may imply that there are higher risks associated with this business.

An impending dividend cut

Companies which trade at high yields may appear to do so because investors are pricing in a potential cut in dividends. The trailing 12-month dividend yield may, therefore, be misleading as a reduction in dividends would translate to a much lower dividend yield in the future.

However, investing is about understanding the prospects of the business. Therefore, the investor needs to be aware that moving forward, a cut in dividends may bring the dividend yield back in line with the average. He has to factor this in when making an investment decision so as to not get blind-sided.

Stick with sustainable dividends

My recommendation is to stick to companies and businesses which can pay a decent, yet sustainable dividend. If a dividend yield seems too good to be true, investors should start becoming wary, and they should sniff around for more information before committing their money. Investors are advised not to be seduced by the “dark side” of chasing high dividend yields, as they may encounter situations where dividends are slashed, resulting in weaker prospects for companies and also a crash in share prices.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.