These Dividends Could Crush Your Portfolio

With Treasuries yielding next to nothing and savings accounts or CDs not offering a lot more, investors are swarming to dividend stocks as if it's the next big fad. This isn't necessarily a bad thing: Much research has proven that dividend paying stocks can outperform their non-paying brethren over the long run.

However, you've got to be extremely careful about how you choose to invest. Buying stocks or funds that promise huge payoffs can be extremely dangerous, and if you don't go about it the right way, these investments could crush your portfolio.

Let me explain how.

This is not what it seems to be
Closed-end funds are similar to stocks in that they trade on the open market, which means that their prices aren't tied to their net asset value; they move according to market supply and demand. That means they usually trade at either a premium or a discount to their NAV. Many closed-end funds can be great investments. However, many of them also promise insanely high dividend yields and thus have lured investors into their funds without them doing their proper due diligence.

For example, let's take a look at Cornerstone Progressive Return Fund (AMEX: CFP). This fund boasts an extraordinary 18.5% distribution yield -- an enormous amount of income that any person would be attracted to. Right now you're probably thinking, "Wow, how can I get my hands on that fund?!"

Not so fast.

If you dig a bit deeper, you'll find that these funds have a "managed distribution policy," which means they can return to investors not only a regular dividend, but also long-term capital gains -- and even some of your original capital. However, capital gains and original capital shouldn't be included in this calculation, as it can be chopped pretty easily at any time. If you look closer, you'll see that Cornerstone's "income only" yield is just 2.5%, which is less than what many blue chips in the S&P 500 can get you. In addition, the fund is trading at a 33% premium, meaning that investors are knowingly paying more than they ought to for this fund. It just doesn't make that much sense.

You might be thinking, though, that any stock can cut or decrease its dividend, so what's the big difference? Well, that's partly true. Regular, publicly traded companies have every incentive to not cut their dividends because analysts will often downgrade them, investors will flee, and it tends to lead to a decrease in share price. Closed-end funds, on the other hand, can chop a dividend and in the past have often done so without much of an explanation.

How long can these last?
Other potential pitfalls for your portfolio are companies that pay really high dividends, but their dividends are mostly dependent on macroeconomic events or things out of their control. For instance, real estate investment trusts Annaly Capital Management (NYSE: NLY), spin-off Chimera (NYSE: CIM), and Hatteras Financial (NYSE: HTS) all pay dividends above 13%, but they rely heavily on short-term interest rates staying extremely low. Basically, these companies borrow money on the cheap, invest in mortgage pass-through securities, and see a nice fat profit when all is said and done.

There's nothing wrong with these investments, but you should expect their distributions to be lumpy at best. Annaly, for example, was paying a $0.50 quarterly dividend in late 2004, a $0.10 dividend in late 2005, and most recently paid a $0.64 dividend. This is not exactly the cornerstone of consistency.

You may be better off elsewhere
Instead of only focusing on which companies are paying the highest yields today, you'd be better off looking at companies that pay solid dividends, have done so historically, and have room to grow in the future. Here at the Fool we often talk about the Dividend Aristocrats as a great place to start;  these are companies that have been able to increase their dividends for 25 years consecutively -- no easy task considering the two enormous recessions we've experienced in the past decade.

Here are three stocks I think have great potential and that have also illustrated their capabilities over the past 25-plus years:

The Foolish bottom line
I know, these probably don't seem like the most exciting investments, and they certainly won't make you rich overnight. If that's what you're looking for, then you're looking in the wrong place. However, if you hold them over the long run, these investments have the potential to generate huge returns for your portfolio -- without taking you on a roller-coaster ride. Sometimes it's better to sleep soundly knowing your portfolio is in good hands, than to toss and turn worrying about the next dividend to get cut.

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