These Dividends Don't Stand a Chance

Stocks have finally bounced off the bottom, in one of the most dramatic rallies we've seen in years. But if you think that all the risk is gone from the stock market, you might be setting yourself up for more losses going forward.

Investing forces you to balance fear and greed. You don't want to lose money, but you also don't want to miss out on gains, especially when everyone else is making money in stocks. As easy as it is to get swept up in the emotional highs and lows of changing market conditions, the best investors merely use the market's overreactions as an opportunity to earn profits -- or preserve past gains from increasing danger.

Yields and you
Nowhere is the tension between greed and fear more obvious than in high-yielding dividend stocks. On one hand, the prospect of earning huge returns, even if a stock's price doesn't move a penny, sounds great. Just look at the fantastic yields that some stocks are paying now:

Source: Yahoo! Finance, Motley Fool CAPS.

But as you can see from the lackluster ratings these stocks received from our Motley Fool CAPS community, they're not risk-free. Just as stocks like General Electric and Dow Chemical announced dividend reductions recently, the odds are good that some of these stocks won't be able to keep paying their own high yields indefinitely.

The problem with high-dividend stocks is that if those dividends go away, you're likely to suffer twice. Not only will you stop getting those monthly checks in the mail, but you'll also see an exodus from other fickle shareholders who owned the stock solely for the dividend. Their hasty departure typically slams share prices.

That double-whammy can make you feel stupid for stretching for an extra few percentage points of yield. And even if some of the stocks you've picked do keep paying those high dividends, the losses you suffer from those that don't could more than offset your gains.

Be realistic
The more prudent approach to dividend investing is to match up risk with yield. For instance, if you can reduce your risk of a dividend blowup by taking a somewhat smaller dividend, then it's well worth it.

One aspect of a healthy dividend payer is a reasonable payout compared to its earnings. Here, for instance, are some stocks with low payout ratios that still pay a good dividend:

Source: Yahoo! Finance, Motley Fool CAPS, DividendInvestor.com.

Because these stocks have the earnings to back up their yields, you have more assurance that these companies won't have to cut dividends going forward. And while there's no guarantee, lowering your risk of a dividend blowup will enhance your overall returns.

Look for the cash
To be on the safe side, though, earnings aren't necessarily enough. You also want to make sure that companies have the cash they need to pay dividends.

So in addition to looking at earnings, also pay attention to whether dividend payers are generating enough free cash flow. Each of the companies with favorable payout ratios listed above had positive free cash flow over the past 12 months, but in some cases, the amount of capital expenditures made their reported free cash flow lower than their reported net income.

Be careful
Over the long run, dividend stocks have done a good job of providing strong returns for investors. But given how uncertain investors are right now about the state of the economy and the future of their stocks, you should think twice before you try to grab a few extra pennies on a dividend that may not be sustainable.

More on dividend investing:

• The worst news for dividend investors in 53 years.
• Why you should avoid this investment.
• Don't lose a fortune.