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The Dividend Stock Lesson That Could Be Worth Thousands of Dollars to Investors

By Jason Hall - Dec 6, 2020 at 8:05AM

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Chasing yield can lead you to fall for a bad business.

When looking for the best dividend stocks, investors typically start by searching for the highest yields. Unfortunately, this approach often leads to underwhelming results -- and, in many cases, unexpected losses totaling thousands of dollars. 

On Motley Fool Live on Oct. 29, "The Wrap" host Jason Hall and Motley Fool contributor Danny Vena talked about the risks of falling for a dividend trap and what you can focus on instead to generate the best returns from dividend stocks.  

Jason Hall: Sometimes the stocks that pay the highest yields are companies that might be troubled. They might be paying a high yield because the stock price has fallen. Because there's some troubles with the businesses that other investors have already identified, and investors have sold the stock because they are expecting the price is going to fall, or they are expecting the dividends are going to get cut. So the stock price has already fallen in anticipation of that dividend cut.

You walk into a dividend trap because you start backwards, you start by looking for the biggest yield and you end up buying the worst business because the market's already figured out that the dividend is not going to be a sustainable thing. The point here is if you're looking for dividends, but your primary objective, because there's two reasons to buy dividends. There's dividends just because they're going to add to your returns, and there's dividends because you need a source of income. We're going to talk about dividends as a source of income as we go on. Because then you do start focusing more on the higher yield.

But if your primary objective as an investor is just to generate the best returns you can, Danny, myself, for the most part, that's where we are because of our age and our goals, and where, and how far those goals still are. But if you're just looking to get the best returns, don't start by chasing the biggest yield. Buy high-quality businesses that have great dividend growth track records, another one is, go ahead Danny.

Danny Vena: I was going to say, I have a great example of what you were just talking about. I bought a company that I thought was a solid business and it had a pretty decent dividend yield, and I went outside of what I would normally buy. I bought shares of AMC Entertainment (AMC -0.15%) a few years back. They were spending a lot of money. They acquired a lot of debt so they can upgrade their theaters, and there were plenty of red flags there that I should have looked at. But I was also looking at the dividend yield and thought, "This is really attractive dividend yield and I can get paid while they turn the ship around."

Well, guess what? Now, AMC Theaters is doing horribly. Theaters are shut down. All that debt that they took on is getting ready to bite them in the keister, and that dividend's not looking so good anymore, is it?

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AMC Entertainment Holdings, Inc. Stock Quote
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