What Is a Dividend Yield Trap?

When you're shopping for a dividend stock to invest in, bigger isn't always better. In this Industry Focus: Financials, host Michael Douglass and Fool.com contributor Matt Frankel discuss the concept of a dividend yield trap and why investors should avoid them.

A full transcript follows the video.

This video was recorded on April 30, 2018.

Michael Douglass: One of the first things that I see plenty of people do when they start screening for stocks or funds is to look for high dividend yields. And it kind of makes sense, in theory. A dividend is this income that theoretically, hopefully, you can count on, so, a lot of new investors like immediately looking for that sort of thing.

Matt Frankel: Sure. All things being equal, of course you want a higher dividend yield. Just to give you a personal example, when I was trying to decide between AT&T (T 1.30%) and Verizon (VZ 0.88%) for an investment, the fact that AT&T had a higher yield when pretty much the rest of the business I valued the same way, give or take, played a big role in my decision to choose AT&T over Verizon for my own portfolio. So, all things being equal, higher dividend yields are obviously better. You want dividends to compound over time. A higher starting payment will allow you to compound more over time. But, there's a little problem behind that, which we'll get into in just a second.

Douglass: Yeah, and that's that really high dividend yields -- now, how do we define that? There's nuance there, and we'll get into that a little bit further down the line. But, really high dividend yields sometimes signal trouble. There's this thing that happens to a lot of new investors, and it actually happened to me, where folks will see this really high yield and say, "OK, great, this is the business. It's a 20% yield, how can I lose money?" This happened to me. Trust me, I lost 99.9% of my investment. Best $200 I ever lost, by the way, or I have ever spent on just about anything, because I learned so much about how not to invest off that. I think you have to first learn how not to invest before you figure out how to invest.

But, we call these yield traps. It's essentially a stock that has a massive dividend and people buy it because it looks like such a juicy dividend. The problem is, the business itself is actually fundamentally in a shaky spot, and there's a lot more risk than you usually associate with a dividend stock. We call that a yield trap.

Frankel: A yield trap, like Michael said, either there's something wrong with the business -- it could be a declining market. It could be that they're using a ton of leverage. There's a bunch of different reasons which we'll get into more specifically in a minute. But basically, a dividend yield trap is a case of, if it's too good to be true, it probably is. [laughs] And there are a lot of high-yielding stocks that should immediately set off red flags in your head as an investor.

Douglass: Right. I received two listeners questions in the last week and a half about dividend funds that I viewed as yield traps. I have no idea if that was tied to a screen that they'd done as a result of Vince and Asit's fantastic episode, but we figured this was a great opportunity to talk about yield traps -- it was kind of on my mind anyway -- and really talk through what that looks like, on the general idea that, where two are emailing, perhaps many of the other dozens of our podcast listeners are thinking about some of this and maybe have already performed some screens and found some really high-yielding dividend stocks.

On today's episode, we're going to talk through dividend yield traps conceptually, and then go through some examples of stocks that Matt and I view as potential dividend yield traps. If you're interested in learning more about this concept and how to avoid them, we've put together some great resources for you: a dividend yield trap checklist based off today's episode, and an in-depth article that further explores the concepts we're covering today. If you want those, send us an email at [email protected] and we'll be happy to send those along.