Suppose you've been sitting on $50,000 in your retirement account waiting for stock market growth opportunities that never materialize. All of the discount stocks you've bought are slowly making up their ground, and your index funds are matching the market. Then someone comes along and makes you wonder if you're missing out on great returns by chasing higher dividend yields! Maybe it's an article talking about "the top four stocks for dividend payouts in the next year". While value investing tends to pay off over time when you buy low and sell high, a dividend payout can be nice if it's a regular quarterly, semi-annual, or annual payout. Then you can turn right around and reinvest that money while keeping the underlying stocks. What's the catch? (You know there's a catch!)

Where Do High Dividend Yields Come From?

High yields often come either from stocks that have very attractive payout ratios or are trading at low prices (or both).

Low prices are good. That's the heart of value investing.

The math is important, though. Remember that a dividend yield depends on the price you paid. A stock which pays $7 per share but costs $700 per share has a 1% dividend yield. If the price of that stock dips to $100 per share and the payout per share remains $7, the yield is now 7%! That's fantastic--if the cost per share is worth it.

On the other hand, a company with a stock worth $10 per share could pay out $0.70 in dividends to make a 7% dividend yield. The stock might not be worth any more, but if there's nothing else the business can do with the money, trying to induce new buyers chasing high yields could raise the price. That's not a bad thing necessarily, but it doesn't reflect the goodness of the underlying business.

Think about that implication for a moment.

A Dividend Yield is a Point in Time

That $10 stock paying out $0.70 might be a great stock, but if you buy $1000 shares, but the stock tanks right after the payout and you sell it at $2, you've lost $800 to make $70 and lost $730 overall. That's hardly a great return. On the other hand, now it has a 35% dividend yield (though it's probably not going to pay out $0.70 per share if all of this happens).

It's important to consider the entirety of your purchase. Without a guarantee that you'll get the same or higher dividend payout each time, you could watch the effective value of your portfolio diminish and your rate of return dwindle.

Unless the business itself can sustain both the free cash flow necessary to provide profits to fund dividends as well as the business strategy to pay out those dividends, what's attractive right now may not be attractive in the future.

Alternatives to Dividends

What's more important than a reliable payout? That depends on your investing goals. Maybe nothing is more important.

If you're looking for ways to grow your money over time, you have to know where that growth comes from. It all comes from the ability of the business to make money and to reinvest that money to make more money. Every dollar of profit spent reinvested in the business is a dollar that can't be paid out in dividends.

Again, that might be the right approach for the business, but it's a specific tradeoff to understand!

Pitfalls of High Dividend Yield Stocks

To maximize your return, you must avoid several risks:

• Poor earnings per share. A company with unsustainable earnings will struggle in the short term.
• Cyclical business trends. A utility company may weather a recession better than most other businesses (people still need electricity, water, etc), but when the economy improves, it may not perform nearly as well in comparison.
• Too much debt. A business can accelerate its growth by borrowing money, but the cost of repayment is always a cost!
• Non-market forces, such as political risk (tariffs), general instability (currency exposure), or unpredictable emergencies (earthquakes, hurricanes, extreme weather).

While you can't predict everything, you can measure the company's previous performance.

As with any investment, pay attention to solvency, liquidity, and creditworthiness for the current business. Think about the potential for earnings, future sales potential, and potential growth, as well as financial strength and competitive positioning. Your goal is to minimize risk and improve your return, not eliminate risk and maximize return.

Should High-Yield Stocks be in Your Portfolio?

Maybe! Are they stocks worth holding otherwise? If so, you've found gems! If not, then you need to manage your risk according to your goals and taste.