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