Dividend-paying stocks have given investors strong performance over the long run and solid protection from the worst ravages of last year's bear market. Yet as dividend stocks have started to become more popular, some now believe that they could be getting ahead of themselves.

Raising the alarm
Over the weekend, The Wall Street Journal published an article warning investors to be cautious about dividend stocks. The article raised three basic points:

  • Yields on other income-producing investments like cash and bonds have fallen sharply, leaving investors in a position where they're stretching to find the income they need.
  • In response, many income investors are moving their money into dividend stocks.
  • Despite beating the market, dividend stocks in general declined substantially last year, leaving shareholders with big net losses even after considering the income they generated. Some stocks in particular have especially disappointed dividend investors, most notably financial stocks that both slashed their dividends and suffered huge losses.

In conclusion, the article reminds investors that there's a place for conservative investments like cash and bonds in your portfolio, even when they're not paying high rates.

A response to the risk argument
I certainly agree that if you're thinking about cleaning out your savings account and all your liquid cash to invest in even the safest dividend-paying stocks, you're making a huge mistake. It always makes sense to have money ready and available to meet your immediate needs without taking the risk of having to sell stocks during a down market.

But as even the Journal admits, there's risk involved in investing in bonds and cash. With bonds, higher interest rates can create losses of principal if you invest in bond mutual funds or don't plan to hold individual bonds to maturity. Ultra-safe Treasury bond investors have seen some pretty big losses lately, with the average long-term government mutual fund down over 15% so far in 2009. And although high-yield corporate junk bonds have had impressive returns this year, their terrible performance in 2008 shows that investing in corporates carries its own share of risk as well.

Making the right choice with risk
More importantly, rather than assuming that investors are taking too much risk by moving into dividend-paying stocks now, many investors may well simply be returning their stock exposure back to normal levels after having kept money out of the stock market during the financial crisis.

If that's the case, they could certainly be taking more risk than buying dividend stocks. Given how many investors chase performance, you'd expect many to gravitate toward stocks like Bank of America (NYSE:BAC) and Ford Motor (NYSE:F), which have seen their shares rise substantially off their recent lows. In comparison, many dividend stocks haven't gotten nearly as expensive even after the recent rally:

Stock

Current Dividend Yield

2008 Return

2009 Return (YTD)

Abbott Labs (NYSE:ABT)

3.0%

(2.4%)

3.7%

Chevron (NYSE:CVX)

3.5%

(18.0%)

8.7%

H.J. Heinz (NYSE:HNZ)

3.9%

(16.0%)

17.5%

Kraft Foods (NYSE:KFT)

4.3%

(14.3%)

3.0%

PG&E (NYSE:PCG)

3.7%

(6.5%)

19.3%

Source: Yahoo! Finance. Data current as of Dec. 11.

You can see how the risk/reward relationship has played out with these stocks over the past couple of years. During 2008, these stocks performed extremely well compared to the overall stock market, yet they still created losses that would have been unacceptable to anyone with an extremely short time horizon for their investment.

This year, though, many dividend stocks have failed to keep up with the broader market's advance. That's clearly unfortunate for those who bought them earlier this year in the hopes of a bigger rebound. But it also means that unlike many other stocks, dividend payers still look like a fairly good value even with the market well off its recent lows.

Don't give up on dividends
So even though dividend stocks are getting a lot of attention lately, they're still a smart buy for many investors. Although they're certainly not a good short-term alternative for cash, they offer fairly low risk at attractive valuations right now. That's worth the attention of any investor who can afford to take at least some risk in today's market.

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Fool contributor Dan Caplinger followed dividend-paying stocks down and up during the crisis and ensuing rally. He doesn't own shares of the companies mentioned in this article. H.J. Heinz is a Motley Fool Income Investor recommendation. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy helps keep you smart.