The 7 Deadly Sins of Dividend Investing

Being aware of these common pitfalls should help you avoid making the mistakes that can impair your long-term results

Todd Wenning 6 August, 2012 | 4:34PM
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As interest rates have fallen for gilts, savings and bonds in recent years, investors have increasingly turned to shares with high dividend yields as a way to compensate for lower rates elsewhere in the market and grow their income stream and capital base in the longer-term. While there are plenty of benefits to building a dividend-focused portfolio, it’s critical to be aware of the seven "deadly" pitfalls and mistakes associated with the strategy.

Reaching for Yield
Ultra-high dividend yields (8%+) can be particularly attractive in this low-return environment, but it’s important to resist the temptation to load up on these shares. Most ultra-high yields are simply too good to be true and are more often a product of a poor outlook for the company than a generous dividend policy. Indeed, a recent study by Société Générale found that "an abnormally high yield is generally a sign of distress" and showed that groups of shares in the ultra-high yield categories are more likely to have lower realised yields. This makes sense—given that shares have historically returned about 8% to 9% over the long-term, a share paying a sustainable 8% yield should be very attractive to investors. But if all investors agreed that the share’s 8% yield was sustainable, they would pile into that share and as a result drive the yield down. Every so often, the market gets it wrong and there can be bona fide opportunities in the ultra-high yield space, but more times than not the market gets it right, and investors who reach for those yields get burned.

Disregarding Valuation
One school of thought in constructing a dividend portfolio is to buy shares for their yields alone, to focus only on the income and pay little attention to valuation. While focusing on income may save you from making emotional trading decisions based on share price volatility, constantly overpaying for shares is not a formula for success, either. Always insist on buying shares with a "margin of safety”—that is, at a meaningful discount (at least 10-15%) to your fair value estimate.

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The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Todd Wenning

Todd Wenning  is an equities analyst with Morningstar.