3 Reasons To Exercise Caution When Buying Dividend Stocks

Today’s unsettled economic situation leaves many scrambling for investments that can provide some stability. One option we hear promoted quite a bit among stock boosters: dividend stocks. Unfortunately, there are some things they won’t tell you…

There’s no question, we are living in interesting economic times.

This year is already off to quite a start, as Wall Street investors are “bracing for” the Fed’s first rate hike in three years. Of course, that’s just one piece of the economic puzzle as 2022 starts to take shape.

Higher prices, no longer merely “transitory,” are expected to linger for a while. The U.S. national debt is at $29.6 trillion, and near-zero interest rates guarantee lost purchasing power on virtually everything from savings accounts to speculative-grade (aka “junk”) bonds. The exuberant stock market’s current valuation is historically high…

This situation leaves those of us saving for retirement scrambling for investments that can provide some stability. One option we hear promoted quite a bit among stock enthusiasts: dividend stocks. So why do so many people say such great things about them?

These are primarily large, established “blue chip” companies that have a track record of paying shareholders on a quarterly or annual basis. For example, USA Today recently offered 3 reasons we should consider dividend stocks for our savings:

  1. Potential income. Dividends “generate regular income streams, but they still experience market volatility. Some companies decide to take their profits and distribute those to shareholders. These are usually mature, stable companies with limited growth potential.”
  2. Tax treatment. “Investment returns in a Roth are distributed tax-free prior to age 59 and a half are also tax-deferred within traditional IRAs and 401(k) accounts. However, when you take distributions from those accounts, they will eventually be taxed as ordinary income.”
  3. Dividends offer a measure of stability. “Dividend stocks are a great source of growth, but they also offer more stability than the market in general.” (We’ll get to this last part in just a minute).

Taken at face value, this sounds like a great idea, doesn’t it? There’s another side to the story, though. Retirement savers must appreciate the full picture to make an educated choice…

The downside of dividends

Here at Birch Gold, we believe in education and empowerment. To that end, there are at least three things to understand before investing your hard-earned retirement dollars into dividend stocks. They aren’t things your financial advisor, broker or stock-boosting cable channel are likely to point out or emphasize.

Here they are, presented in no particular order:

1. How do you figure out which dividends produce “reliable” returns?

Dividend stocks might look great on paper, but they still fluctuate with the stock market. Their prices tend to go UP when the market goes up (when you don’t need them to). Conversely, they tend go DOWN when the market goes down (when you don’t want them to). In other words, they follow the trend.

Dividend stocks do tend to have a lower beta measurement than the broad market. Beta is a measure of “systemic risk of a security compared to the market as a whole.” A beta of 1 means an investment moves in lockstep with the stock market. Lower than 1 means less movement, and greater than 1 means more movement. Investopedia tells us:

A beta value that is less than 1.0 means that the security is theoretically less volatile than the market. Including this stock in a portfolio makes it less risky than the same portfolio without the stock. For example, utility stocks often have low betas because they tend to move more slowly than market averages.

Let’s take a look at that example:

The Vanguard Utilities Index Fund ETF Shares (VPU) currently has a 10-year beta of 0.3 On average, we’d expect a share of VPU to go up and down about 1/3 as much as the overall stock market. So VPU shares would follow the general market trend, just more sluggishly.

The return on investment they deliver needs to exceed inflation, on average. And that’s where experts who favor dividends lean on statistics to make their case. That said…

2. Long time frames and averages only reveal part of the story

As Compound’s Charlie Bilello said,

By changing the start and end date, you can win just about any argument over what’s the best investment.

That sounds a little silly, but it’s also true.

For example, David Van Knapp revealed a “sleight of hand” that can be used to make dividends look better than they are.

At first, dividends appear to be the best investment since Microsoft-in-2008:

There is no question that over very long time frames, dividend growth has handily exceeded inflation. Year-by-year, dividend growth was higher than inflation in 31 of 51 years. The average yearly rate of dividend growth (5.4%) exceeded the average annual inflation rate (4.1%) by 32%. [emphasis added]

The problem is, anyone who is saving for retirement now doesn’t get the benefit of returns that happened 30 years ago.

Van Knapp explains that there were only 12 years in the last 51 in which dividend growth eclipsed the latest CPI report of 6.8%. That number (which could rise even higher) is the one that retirement savers care about today.

In addition, there’s the risk that any stock could simply stop paying dividends altogether.

3. Companies that pay dividends aren’t immune to black swans

Dividends are not a guaranteed investment. Any single company that pays dividends can go out of business, and they have in the past. Remember Indymac, Thomas Cook, or Lehman Brothers, or Bear Stearns, Merrill Lynch, Washington Mutual? Global Crossing, Enron or WorldCom? If you have a little gray in your hair, you can add Pan Am, Long-Term Capital Management, Kmart and Texaco to the list…

Any company can suffer a surprise reverse, like BP’s Deepwater Horizon or Exxon’s Valdez oil spills. A concentrated position in any single stock, no matter how great its fundamentals and solid its dividend track record, simply isn’t judicious for most people.

The big takeaway here? Prudent investors pay attention to both the pros and cons of their investments. They don’t put all their eggs into one basket. And they educate themselves about a variety of asset classes when preparing their retirement strategies.

Winning the retirement game

For some people, dividend stocks may in fact be worth a closer look (along with other inflation-resistant investments). We’re not taking sides here, merely offering a full perspective of the discussion.

Like many other investments, dividend stocks that look good on paper have some of the same drawbacks as the broad stock market. They’re a riskier choice when the market is expensive (like it is now). Especially with consumer prices on the rise.

So if you’re looking to add stability to your retirement savings, you owe it to yourself to have all the facts. And if you’re looking for a “safe haven” for your savings, consider tangible assets like physical gold and silver. Their track record during uncertain markets may be exactly what you need as a counterweight to less-predictable assets.

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