Beware Of Yield Traps

Thu, Jul 22, 2010

Financial Advice, Investment

Investors seeking an income stream from their holdings gravitate to either bonds or stocks which pay a dividend. Many stocks do not pay a dividend, and consequently there is no income provided from their ownership until the position is sold. Cash flow is especially important to those just entering retirement when income from investments becomes paramount. A wide variety of “blue chip” stocks pay dividends, and the typical yield is between 1% and 5%. The yield is calculated akin to an interest rate — for example if you buy a stock priced at $20 and you are paid a $1 dividend each year, then the resulting yield is 5%. A 5% dividend has advantages over a 5% yield bond or CD — dividends are taxed at a lower rate, and dividends can also be raised going into the future as opposed to static interest rates paid on CD’s or bonds.

However, investors need to be very wary should a dividend yield be too high. Any stock with a dividend yield over 5% should be highly scrutinized for risk — when the market allows dividend yields to get this high, in many instances that signifies impending trouble for the company. A well known recent example of this phenomenon is with BP. The dividend yield on BP shares exceeded 10% — quite an attractive proposition for an income stream for your investment. However, that income might prove to be illusory if BP cuts the dividend in the future — or goes bankrupt due to the oppressive costs of cleaning up the Gulf spill. The bottom line is that there is no free lunch — when something looks to good to be true, it most often is. This is especially salient within the world of high yield dividend stocks.

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