The Easiest Way To Lose Money In The Stock Market

posted on 06-07-2019

It's tough to retire on a 2% yield.

Factor in inflation, and you're all but guaranteed to lose money on many traditional income products, including high-quality government bonds, bank certificates of deposit and savings accounts.

Even riskier corporate and government debt is currently offering paltry yields. Consider that Spanish 5-year bonds currently yield just 4.1% despite the fact that just six months ago, some were speculating the nation could be forced out of the euro or would need to restructure its debt burden. That's a lot to ask for taking on all those risks for such a low yield.

In such an environment, there's nothing quite like a fat, double-digit yield to attract investors' attention.

But while most investors might salivate at the prospect of a double-digit yield, smart investors should be cautious.

Let me explain...

Many investors equate dividends with safety. After all, some of the best dividend-paying stocks are solid companies with a long operating history and consistent cash flows. And over the past decade, stocks offering dividends have outperformed the broader market.

But, stocks offering 10% yields and higher in the current low-yield environment are often downright speculative. There's no free lunch on Wall Street. If a stock is paying a sky-high dividend yield, it's often because investors expect the firm to cut its payout. Many of the highest-yielding stocks are cyclical and exposed to risks such as an economic slowdown or a slump in commodity prices.

Raymond F. DeVoe, a widely read economist for Legg Mason, once noted that more money has been lost reaching for yield than at the point of a gun.

Based on the experience of the past year, he's absolutely correct. At the end of 2011, there were a total of 11 stocks in the combined universe of the S&P 500 and Bloomberg Europe 500 indexes with an indicated yield over 10%. One year later, these stocks had risen an average of just 4.5% in a year when the S&P 500 was up over 16% and the Bloomberg Europe 500 was up nearly 20% in dollar terms.

That's not to say investors can't make money from stocks offering strong yields. It's simply a matter of being selective and paying attention to macroeconomic and industry-specific factors that might prompt a stock to cut its payout.

But it's also important to consider other factors besides just a company's yield. Specifically, some of the best-performing income stocks are those that offer a single-digit yield and boast a history of consistently boosting their payouts to shareholders.
 
Just look at Procter & Gamble (NYSE: PG). Its dividend yield has stayed below 3% for much of the past decade, even though it's raised its dividend payment by 173% -- from $0.21 per share to $0.56 per share -- over that time. With the company boosting its dividend payment 10 times in the past 10 years, you'd think its dividend yield would be much higher than it's been.

But because every time the company has increased its dividend, investors have jumped to buy more of the stock, driving up the price and keeping the dividend yield low as a result. The upside of course is the healthy gains from holding on to a dividend-growing stock like this -- if you invested in P&G 10 years ago, you'd be sitting on a total return of 121%. And thanks to the dividend raises, you'd also be collecting an effective yield of 6.6% on your original investment.

Compare that to Frontier Communications (Nasdaq: FTR). With a dividend yield of 10%, it's the second-highest yielder in the S&P 500. But because of its mixed earnings reports over the past few years, no dividend raises and two dividend cuts, investors haven't exactly flocked to the stock. If you had invested in Frontier 10 years ago, your dividend payment would actually be 60% smaller now than it was ($0.25 per share to $0.10 per share), and your total return would amount to just 1% -- even with the large dividend yield.

That's exactly why you shouldn't blindly chase every high-yield stock you see.

This philosophy -- buying shares of solid companies that boost their payouts regularly -- is a cornerstone of my Top Ten Stocks newsletter. That's because this is one of the single best ways to make money in the stock market -- and it doesn't take a rocket scientist to execute this strategy, either.

Simply find cash-rich companies with wide-moat business models paying decent yields, and let the rising payouts do the rest.

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