Don't Doom Your Dividend Portfolio

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Dividend-paying stocks offer a powerful combination of current income and growth potential that many investors find extremely attractive right now. But as you look for stocks that pay the top dividends, you have to stay aware of one pitfall that can easily put your entire life savings at risk if you're not careful.

Putting all your eggs in one basket
Often, investors who gravitate to dividend stocks are on the more conservative side of the investing spectrum. Unlike bold growth investors who prefer companies that reinvest every spare penny back into their businesses to grow as quickly as possible, dividend-seeking investors look at the tangible return of cash to shareholders on a regular basis as a safety net against rash corporate action or even outright fraud. In that sense, some associate dividend stocks with safety.

But putting together a diversified portfolio of dividend stocks requires some forethought. Otherwise, it's easy to end up being overconcentrated in particular sectors of the market and owning stocks that will move in lockstep with each other -- for good or ill.

For instance, say you start out by grabbing stocks with the highest dividend yields. That may sound like the ticket, especially if you're looking to maximize your income potential. When you look more closely, though, you'll see that on that list, eight of the top 10 stocks are mortgage REITs. And while not all mortgage REITs are exactly alike -- Chimera Investment (NYSE: CIM  ) invests in non-agency mortgage-backed securities, while Annaly Capital (NYSE: NLY  ) and most of the others prefer mortgages from Fannie Mae or Freddie Mac -- they all have the same basic business model involving leverage, and the same exposure to interest rates.

Going down the list
Even if you go beyond the absolute top-yielding stocks, you'll still notice trends among dividend payers. You'll see a lot of stocks from these sectors:

  • Shipping company Navios Maritime Partners (NYSE: NMM  ) makes generous payouts, although its dividends currently exceed the company's earnings.
  • Master limited partnerships such as Linn Energy (Nasdaq: LINE  ) and Kinder Morgan Energy Partners (NYSE: KMP  ) are designed to give healthy payouts with tax benefits.
  • Telecom companies -- especially ones like Frontier Communications (NYSE: FTR  ) and Windstream (Nasdaq: WIN  ) that focus more on legacy businesses like landlines rather than new mobile technology -- are cash cows and often have yields to match.

Even if you're careful about choosing stocks from each of these sectors, you still won't have as diversified a portfolio as you should -- and you'll be vulnerable to downturns that hit those sectors in particular.

Long-time dividend investors have seen that happen before. During most of the past decade, banks and other financial stocks had extremely attractive dividend yields, as financials thrived under the housing boom and the income it generated. Yet when the housing bubble burst, many of those dividends got severely cut, and share prices plummeted. Those who had concentrated too much on financials suffered the double-hit of losing their dividend income as well as taking big capital losses.

Even dividend ETFs, which you might look to specifically to give you diversification, don't always give you as broad-based exposure as you may want. The iShares DJ Select Dividend Index ETF, for instance, has 10 times the weighting to utilities of the S&P 500, while almost entirely leaving out technology and health-care stocks.

Own the right stocks
As you look for the best dividend-paying stocks, it's important to keep your overall portfolio diversified. By being aware of the dangers of concentrated risk that the most popular and highest-yielding dividend stocks pose to your investments, you'll be able to mix and match from a wide array of different industries and sectors to keep your portfolio as safe as you can.

For some strong candidates for your dividend-paying portfolio, take a look at the free report from the Motley Fool called "13 High-Yielding Stocks to Buy Today." To get instant access to the names of these 13 high yielders, simply click here -- it's free.

Fool contributor Dan Caplinger is always looking for the hidden dividend in everything. He owns shares of Chimera Investment. The Fool owns shares of Annaly Capital Management. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy wears its Fool cap backwards on gloom-and-doom day.

Read/Post Comments (5) | Recommend This Article (35)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 22, 2011, at 9:51 PM, geneandkatie wrote:

    I bought shares of a Master Limited Partnership several years ago. The dividend was nice but this type of investment was a pure headache at tax time. I couldn't get rid of it fast enough. I will never buy another MLP.


  • Report this Comment On April 25, 2011, at 3:35 PM, elainebatista wrote:

    Muito interessante

  • Report this Comment On April 25, 2011, at 4:41 PM, lemoneater wrote:

    By adding foreign dividend payers to my mix I get more variety across industry sectors. US tech stocks don't tend to pay dividends, but that is not always the case with foreign tech stocks.

  • Report this Comment On April 29, 2011, at 11:50 AM, kyith wrote:

    I wonder if you can invest in Master Limited Partnerships as an international investor. i guess i won't gain much upside


  • Report this Comment On July 14, 2011, at 7:57 AM, ChinaXpert wrote:

    Kyith, yes you can but the IRS takes a 30% withholding tax off MLP dividends that are paid to international investors when those MLPs are in the energy space (e.g. KMP).

    As far as I know, other dividends

    (including those from non-energy MLPs) are taxed at 10%, which may compare favorably to the rates imposed by other countries.

    The tax benefit of investing into energy MLPs isn't there for international investors, but it won't stop you from realizing capital gains (by selling the shares), which are not subject to withholding tax.

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