Investing in stocks is a tough business these days even despite a massive multi-year rally where the markets have essentially doubled since their lows after the financial crisis a few years ago. Many investors are still nervous despite the big gains. Everyone loves to have a margin of safety when investing, and some look to dividends as an important safety net. But should they?
Anyone who does individual investing is asking the question whether or not it makes sense to buy stocks after such a large run-up in prices. One of the common opinions on the matter typically comes with a positive opinion on individual stocks thanks to dividends. The argument is how dividends offer a possible margin of safety for downside risk. While I’m a big believer in dividend stocks, especially in the current environment, this “solution” may have its flaws.
The problem is that when stocks are potentially over-valued, buying them at high valuations means you’re locking in a lower yield on your invested capital. Allow me to explain with a simple example.
If a stock is trading at $50, with a $2.50 annual dividend, the yield is 5%. If the market explodes higher, and this same stock moves up to $100 a share, that same $2.50 dividend payout now means the stock is yielding 2.5%.
You lock in a specific yield on your money invested basically determined by the purchase price.
Now, in that same example, is 2.5% enough of a margin of safety for this specific individual stock? It’s hard to answer that questions positively. A 2.5% decline in the example stock from $100 would result in a share price of $97.50. Hardly a massive decline in the stock. If previous years are any lesson, there are definite risks of downside in the stock market of much larger declines than this.
Does this mean we should ignore dividend stocks? Absolutely not. In fact, I love dividend stocks; I just want to encourage you to invest in them for the right reasons.
Dividends are great because you earn a cash flow for your investment. While getting paid to own a stock can be a nice way to lessen your risk, it doesn’t give you free reign to buy overvalued stocks. Other financial ratios and metrics, e.g., earnings per share, growth rates, and price to earnings ratio should be examined prior to making a decision on whether to buy or own such a stock. I would also recommend owning stocks that have a history of increasing their dividend payout on an annual basis. There are several stocks that fit this profile.
Dividend stocks definitely have a place in your portfolio. Unfortunately, because of the major run most stocks have had in recent years, the dividend yields on most stocks have been held in the 2% to 4% range. While the yield is a positive, it’s not enough to cover you in the event of a major market correction. Make sure you’re buying quality stocks for fundamental reasons that you will want to own regardless of near term market fluctuations. Compounding increasing dividend payouts over time can yield great results for your invested dollars.
The articles are written by personal finance enthusiasts (not certified professionals) based on their personal experience. What works for them may or may not work for you, and you should always consult a financial advisor before making important financial decisions.
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