Investing in dividends: what are the risks?

Investing in dividends is often considered a low-risk strategy. This method is particularly popular when markets are in trouble. Investors are looking for royalties, often higher than those they could get from bonds, and which offer them a kind of protection against price fluctuations.

While the idea itself is excellent, it is nevertheless based on a major error: Stocks are not fixed income securities. This means that the dividend paid yesterday may simply be suspended tomorrow. If you pay 50$ for a stock that paid 2$ in dividends last year to receive at least the same amount this year, you run the risk of receiving only 1$, or even nothing at all. Worse, since dividends, earnings and price are closely linked, not only will your investment earn you nothing, but you will also lose part of your initial investment.

 The 4 Risks of Investing in Dividends

1. risk of slowdown
2. risk of stagnation
3. risk of decrease
4. risk of deletion

The risks listed above are due to the fact thata company relies on its profits to pay a dividend to its shareholders. Depending on the performance of business, the strength of the company and the dividend policy, the company will choose to increase its distributions (and by how much), keep them at the status quo, lower them or even eliminate them.

Tartempion has been increasing its dividend by 10% every year for the past five years. You decide that this is a good investment opportunity. However, the following year, the company, following a stagnation in profits, decides that the dividend will be increased by only 5%. You still receive an income, even higher than the previous year, but lower than you expected. This is the risk of rslowdown of the progression of distributions. The consequences are benign, unless the growth rate remains below 3% in the long term, running the risk of a loss in the value of the dividend, due to inflation. A drop in dividend growth is also an interesting indicator that can announce the start of a bad run, and lead us successively towards the three other risks listed above.

The more the distribution ratio increases, the greater the share of profit distributed to shareholders becomes, and the less room there is for the company to continue increasing its dividend. At a certain point, if profits continue to stagnate, the company will simply no longer be able to increase its distributions. This is the risk of stagging. Many investors would already be happy to be able to secure a fixed income, as they could from bonds. Since stocks are not fixed income securities, companies that manage to ensure a dividend that is at least constant can be considered worthy of interest. This is true, however the problem arises, as with the risk of a slowdown, when this situation persists over the long term, because of the loss of value due to inflation. If the slowdown is only a simple indicator, the stagnation of distributions is a real alarm signal, the last step before a reduction or even elimination of the dividend.

When profits are no longer stagnant but are falling significantly, the company may be forced to reduce the amount it pays to its shareholders. This is particularly the case when the distribution ratio is already high. The risk of dividend reduction is serious. If you bought 10,000 $ of Tartempion shares hoping to get 400$ in dividends per year and the following year, due to financial difficulties, the distributions only bring you 200$, the return compared to your purchase cost will have been halved. While at first glance, with a return of 4%, the company seemed like a good investment, you are ultimately making a very bad deal, especially since the share price will undoubtedly have fallen at the same time. In this case, you would have done even better to buy bonds.

But there is worse still, the risk of dividend suppression. The Tartempion company is in such bad shape that it can no longer pay its shareholders, and this could last for several years. It's as if you were the owner of a building and your tenants no longer paid you rent. Worse, at the same time your land is losing value. Indeed, the share price, which contains the value of profits and dividends, collapses as soon as the latter disappear.

Note that depending on the financial situation of the company it is possible to move directly to the phases of reduction and even elimination of the dividend, without going through the stage of slowdown and stagnation. This is what happened to the banks in 2008.

The chart below tracks the performance of dividend-paying stocks (Dividend Growers), those with no change in dividends, and those that are cutting or eliminating their distributions (Dividend Cutters or Eliminators). Not surprisingly, Growing dividends beat the market. Stagnant dividends are underperforming the market, but their performance is positive. This is a good warning signal. The performance of reduced or eliminated dividends is simply catastrophic., since it shows a loss over almost thirty years.