Tags: Recognize | Dividend | Traps | Portfolio

How to Recognize Dividend Traps in Your Portfolio

Wednesday, 09 May 2012 01:31 PM

Which dividend stocks are right for you? If you said “high payers,” it’s probably time to reconsider the risk you might be taking, perhaps unconsciously.

Investment advisers often are pro-dividends. They know, for instance, that a large percentage of the so-called “total” return on stocks — appreciation plus dividend income — comes from the dividend side. Stocks go up and down in price, but dividends are typically predictable, particularly from consumer goods makers.

Meanwhile, retirees need income. The current era of rock-bottom interest rates has sapped their ability to generate cash on a consistent basis from the sources they have long used: CDs and money market funds.

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Fixed-income tools such as money markets are in the basement these days because they get their income from buying and managing U.S. Treasury debt. With Federal Reserve benchmark rates near zero, the 30-year Treasury is eking out a yield of just over 3 percent. The 1-year T-bill is at zero.

Money for nothing.

Hungry for return, investors have been piling into dividend stocks, pushing up prices and lowering yields there, too. It can be tempting to peer over the fence at high-yielders and assume that the risks are equally low.

Watch out for “dividend traps,” advisers warn.

A dividend trap is a stock that pays a relatively high dividend — well above 3 percent — but is likely to fall in share price, wiping out total return.

There’s no obvious sector to avoid, but an usually high dividend is unsustainable and should be approached with caution.

One measure you can use to judge a potential dividend pick is its “beta.” Used by traders, beta is a way of looking at how much the stock price moves up and down relative to the whole market.

It’s presumed that a beta of 1 is representative of the broader stock market, essentially the S&P 500 Index. Thus, a stock with a “low” beta of less than 1 is less volatile, that is, it moves up and down with less frequency than the market itself.

Conversely, a “high” beta stock is prone to wider swings in either direction compared to the broad market.

Can a high beta stock be bought at a good entry point? Absolutely. Can a low beta stock fall in price and spend months or years languishing? Of course.

However, in general, a high beta stock with a high dividend is more likely to turn out to be a dividend trap. Proceed with caution.

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Wednesday, 09 May 2012 01:31 PM
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