Income investors turn to dividend stocks because of the combination of current payouts and long-term growth that they provide. High-yield dividend stocks are particularly enticing because of the higher dividend payments that they make, but they also involve greater risk that can threaten not just future streams of dividends but also the investment capital that shareholders use to buy those stocks. Investors have to consider both the risk and the reward of high-yield dividend stocks before finding themselves in over their heads. In particular, the following three tips can help you find the best high-yield dividend stocks while avoiding potential dividend traps.
1. Focus on healthy businesses
One essential aspect of dividend investing is to understand that dividend yields can become high for two very different reasons. Ideally, growth in the amount that a company pays to its shareholders each quarter is what results in a steadily rising dividend yield for investor. Unfortunately, what can also push the yield higher is a falling share price that results from troubled businesses facing major challenges.
Many dividend investors make the mistake of focusing on turnaround candidates, thinking that they unify favorable aspects of both dividend investing and value investing. All too often, companies facing financial trouble end up cutting their dividends, resulting in share price declines and delivering a double hit to shareholders. Dividend investors should instead look more closely at the healthy businesses with track records of strong performance, because they're more likely to be able to keep raising their payouts and treating their shareholders well in the years to come.
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2. Keep taxes in mind
The U.S. tax code provides for a lower tax rate on income from qualified dividends on stocks. What many investors don't realize is that not every high-yield dividend investment is eligible for these lower dividend tax rates. For instance, real estate investment trusts often have attractive yields, but their income is typically subject to tax at the higher ordinary income tax rate. Things can get even more complicated with certain other investments, such as master limited partnerships, which offer a combination of tax-favored income, return of capital, and higher-taxed ordinary income distributions.
You can usually got to the investor relations section of a company's website to get tax-related information on the nature of its dividend distributions. Doing so will help you avoid tax headaches and give you fair warning if your high-yield investment will bring a higher tax bill along with it.
3. Turn to exchange-traded funds for high-yield dividend stocks
Because of the risks involved with high-yield dividend stocks, building a focused portfolio that includes just a handful of stocks can dramatically increase your exposure to adverse events. If even just one of the stocks you own suffers an unanticipated setback that leads to a dividend cut, your entire portfolio could see a substantial drop in income production as well as a sizable capital loss.
In order to avoid the risk of a concentrated portfolio, turning to exchange-traded funds that specialize in high-yield dividend stocks can be a good solution. Vanguard High Dividend Yield ETF (VYM -0.20%) offers investors exposure to hundreds of dividend stocks that have yields exceeding the market's overall average, and most of the fund's individual holdings have a very small impact on the overall performance of the ETF. Similarly, iShares Core High Dividend ETF (HDV -0.68%) uses a screen that chooses high-quality U.S. companies that are financially healthy and pay relatively high dividends. Either fund makes it easy to get the high-dividend exposure you want without leaving yourself taking on too much risk.
The benefits of investing in high-yield dividend stocks make it appealing to incorporate dividend stocks into your investing strategy. By keeping these three things in mind in putting together your exposure to dividend stocks with high yields, you'll be able to maximize those benefits while avoiding the potential pitfalls that ensnare unsuspecting dividend investors all too often.
