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13 CHAPTER 2 HIGH DIVIDEND STOCKS: BONDS WITH PRICE APPRECIATION? Sam’s Lost Dividends Once upon a time, there lived a happy and carefree retiree named Sam. Sam was in good health and thoroughly enjoyed having nothing to do. His only regret was that his hard-earned money was invested in treasury bonds, earning a measly rate of 3% a year. One day, Sam’s friend, Joe, who liked to offer unsolicited investment advice, suggested that Sam take his money out of bonds and invest in stocks. When Sam demurred, saying that he did not like to take risk and that he needed the cash income from his bonds, Joe gave him a list of 10 companies that paid high dividends. “Buy these stocks”, he said, “and you will get the best of both worlds – the income of a bond and the upside potential of stocks”. Sam did so and was rewarded for a while with a portfolio of stocks that delivered a dividend yield of 5%, leaving him a happy person. Barely a year later, troubles started when Sam did not receive the dividend check from one of his companies. When he called the company, he was told that they had run into financial trouble and were suspending dividend payments. Sam, to his surprise, found out that even companies that have paid dividends for decades are not legally obligated to keep paying them. Sam also found that four of the companies in his portfolio called themselves real estate investment trusts, though he was not quite sure what they did He found out soon enough when the entire real investment trust sector dropped 30% in the course of a week, pulling down the value of his portfolio. Much as he tried to tell himself that it was only a paper loss and that he could continue to receive dividends, he felt uncomfortable with the knowledge that he had less savings now than when he started with his portfolio. Finally, Sam also noticed that the remaining six stocks in his portfolio reported little or no earnings growth from period to period. By the end of the third year, his portfolio had dropped in value and the dividend yield had declined to 2.5%. Chastened by his losses, Sam sold his stocks and put his money back into bonds. And he never listened to Joe again. Moral of the story: High dividends do not a bond make. If you are an investor who abhors risk, you probably prefer to invest your money in treasury bonds or safe corporate bonds, rather than stocks, because bonds offer a guaranteed income stream in the form of coupons. The trade off is that bonds have limited potential for price appreciation. A bond’s price may increase, as interest rates go down, but most of the money you make on your investment must come from the coupons you receive over the bond’s life. Notwithstanding your aversion to risk, you may sometimes be induced
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14 to invest in stocks by what seems like an unbeatable combination – a stock that delivers dividends that are comparable to the coupons on bonds with the possibility of price appreciation. In this chapter, you will consider why some stocks pay high dividends,
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