For years, investors have turned to dividend-paying stocks as the solution for all their woes. But as we've seen in recent days, dividend stocks aren't without their weaknesses -- and if you expect too much from them, they'll end up disappointing you.
One size fits all
After languishing in relative obscurity during two long bull markets in the 1990s and mid-2000s, dividend stocks finally came to the forefront in the aftermath of the market meltdown three years ago. Battered and bruised from the ordeal, investors looked to dividend payers to fulfill several purposes in their portfolios:
- With many dividend stocks being mature, slow-growth companies in well-established industries, investors saw them as low-risk plays that might not rise sharply but that hopefully would minimize losses in down markets.
- As other income-producing investments like bank CDs and bonds paid ever-lower amounts of interest, cash-starved investors turned to dividend stocks -- especially the higher-yielding stocks available -- to meet their cash-flow needs.
- Even as renowned institutions with long histories of stability came tumbling down during the financial crisis, investors sought security wherever they could find it. They saw stocks with long histories of dividend increases as providing evidence of being able to get through tough times relatively unscathed.
- Finally, some simply turned to dividend stocks in the hopes of earning better overall returns. With studies showing that dividend stocks have outperformed their non-dividend counterparts over the long haul, investing in dividend payers seemed like a reasonable long-term strategy.
All of these explanations are reasonable motivations for investors to have turned to dividend stocks. But as we've learned just in the past week, dividend stocks aren't perfect -- and they definitely carry risk.
The downside of dividend stocks
As an illustration, let's look at the declines in the Dow Jones Industrials (INDEX: ^DJI) over the past five trading sessions. Over that period, the Dow has fallen a bit more than 4%. If dividend stocks were behaving the way you'd hope, they would have held their ground.
Yet many dividend stocks have fallen sharply. AT&T (NYSE: T), for example, has just about matched the Dow's 4% decline, although a $0.44 per-share dividend that took effect during the period cut the loss on a total-return basis to less than 3%. Almost exactly the same thing happened with Verizon, whose price dropped 4.5% but which paid a $0.50 per-share dividend that put it in a market-beating situation. Both stocks are dealing with the balancing act of handling their success in selling popular mobile devices like the iPhone while trying to keep margins up.
General Electric (NYSE: GE) has done even worse than the Dow, falling more than 6%. It's unclear whether investors truly believe in GE's status as a stable dividend stock, especially given that the company had to cut its payout during the financial crisis. Although the company has raised its dividend since then, GE's quarterly payout rate still stands well below where it did before the crisis.
On the other hand, some dividend stocks have done exactly what you would have hoped. Merck (NYSE: MRK) is down just $0.06 per share over the bearish period, perhaps in part because of progress in trying to provide Merck-made cervical cancer vaccines to women in poorer countries at a reasonable cost. Procter & Gamble (NYSE: PG) was down less than 2% over the period, as its defensively oriented business isn't as responsive to changes in the overall economic picture as industrial stocks.
Be careful out there
These short-term results shouldn't surprise anyone who invested in dividend stocks for the right reasons. Clearly, dividend stocks are part of the broader market, and when the market swoons, there's only so much these stocks can do to avoid losing ground.
The key to successful dividend investing is making sure that their favorable traits match up to your expectations. You won't always avoid big market crashes with dividend stocks, but if you're able to tolerate risk in your portfolio, they can make profitable long-term investments given enough time.
Dividend stocks belong in most investment portfolios, but they aren't the only way to invest for retirement. To learn about some other great opportunities, let me extend an invitation to you to read The Motley Fool's special report on retirement, where you'll find three promising stock picks for long-term investors. It won't cost you a thing, but don't wait; get your free report today while it's still available.
Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter here.
