Low interest rates have put pressure on millions of investors who rely on bank CDs and other safe investments for their income. In response, many of them have replaced some of their former exposure to fixed-income investments with dividend stocks. Although making that move will get you a lot more income than a bank CD will, you need to understand the risks you're taking by boosting your holdings of dividend stocks as your primary source of income.
The best way to understand the risks of dividend stocks is to see actual stories of how investors got hurt by owning them. Let's look at five ways that dividend stocks are far riskier than pure income investments.
1. Dividends can get cut.
With bank CDs, you know upfront exactly how much and when you're going to get income payments. Like clockwork, interest comes in every month or every quarter, either paid out to you directly or added to your CD account balance. Bonds and other fixed-income investments tend to be similar, with quarterly or semi-annual payments being the norm, and with fixed interest rates that tell you how much income you'll get.
With dividend stocks, however, you have no guarantee that there's no assurance that you'll receive a dividend. For instance, Spanish telecom company Telefonica (NYSE: TEF ) chose last year not to pay its planned dividend for 2012, saying it would restore half the payout later this year. Even stalwart blue-chips General Electric (NYSE: GE ) and Pfizer (NYSE: PFE ) had to reduce their dividends dramatically during the financial crisis, and even now, they haven't risen back to their pre-crisis levels.
2. Dividend-paying companies can see their stock prices fall.
Bank CDs never drop in value. You may need to pay a penalty if you need to get at your money early, but they're not subject to market fluctuations. Even if your bank fails, bank CDs are insured by the FDIC.
Dividend stocks, on the other hand, move just as much as ordinary stocks. With volatile share prices, you may suffer substantial losses, and although you might still receive the same dividend payments, the stock can stay depressed for a long time if business conditions don't improve.
3. Dividend stocks never mature and return your principal.
With bank CDs, Treasury bonds, and other low-risk income investments, you know exactly when you'll get your principal back. Moreover, with bank CDs and Treasuries, your principal is backed by the full faith and credit of the U.S. government.
Dividend stocks, on the other hand, don't have any fixed maturity date on which you're guaranteed to have your original investment returned to you. If share prices fall and stay low, you may never get your principal back.
4. Fixed income can survive bankruptcy when stocks don't.
Even in the worst-case scenarios, fixed-income securities can give you protection that stocks don't. Even for corporate bonds, which don't have government insurance protection and therefore are subject to risk of default, a bankruptcy can sometimes lead to a partial recovery. For instance, bondholders in the old pre-bankruptcy General Motors (NYSE: GM ) didn't get all their money back, but they did get equity interests in the new company. Old shareholders, on the other hand, got wiped out.
5. Dividend stocks have expensive valuations right now.
Lately, so many investors have bought dividend stocks that their valuations are extremely high. According to one analyst, dividend stocks trade 50% above their normal valuation levels, making them potentially more vulnerable to pullbacks if they return to more typical levels.
Stay aware of risk
To many, dividend stocks have provided income where other investments have failed recently. But with extra income comes extra risk, and you have to take that risk into account in deciding how much of your portfolio you can afford to invest in dividend stocks.
Few companies lead to such strong feelings as General Motors. But ignoring emotions to make good investing decisions is hard. The Fool's premium GM research service can help, by telling you the truth about GM's growth potential in coming years. (Hint: It's even bigger than you think. But it's not a sure thing, and we'll help you understand why.) It might help give you the courage to be greedy while others are still fearful, as well as a better understanding of the real risks facing General Motors. Just click here to get started now.