The Benefits and Pitfalls of Dividend Stocks

When shopping for income funds, yield isn’t everything.

Board showing up and down stocks, funds

When equity markets turn stormy, lots of folks head for the safety of fixed-income assets, which, while costly in the long term, generally provide safety and stability in the short term. But with bond yields at historic lows, even those assets aren't terribly appealing to income-minded investors.

Many investors think they've discovered an income-generating alternative: so-called income stocks, which reliably pay strong dividends. In a world of retiring baby boomers chastened by volatile equity markets, demand for income-generating equity funds is running high: In the first half of the year, dividend funds tracked by data provider EPFR Global attracted net inflows of $14.1 billion, compared with net outflows of $10.3 billion for all U.S. equity funds.

[See 8 Top-Rated Dividend Income Funds.]

There are compelling arguments for holding income stocks, either through mutual funds or exchange-traded funds. The sort of companies that pay strong dividends—think Coca-Cola, Johnson & Johnson, Abbott Laboratories—tend to be larger, mature firms that are often household names. Most have what financial analysts call wide "moats"—meaning market positions that are hard to challenge—so they're less risky than smaller growth companies.

To be sure, dividend stocks are not risk-free. They are stocks, after all, so they often rise and fall with along with the rest of the equity market. From the market's 2007 peak to its March 2009 low, the Dow Jones Industrial Average fell 49 percent, compared with 58 percent for the iShares Select Dividend ETF (DVY), which references the Dow Jones U.S. Select Dividend index. Since then, the Dow is up 80 percent and DVY is up 90 percent.

The reputation of dividend payers can work the other way, too: Because they're perceived as stable and fully formed, they're not necessarily going to rise sharply during a period, like the late-1990s, of surging equity prices. These days, especially, high yields could be misleading. Dividend yields tend to rise when companies are struggling and stock prices are weak, often because the company doesn't want to cut payouts for fear of signaling trouble. A static payout divided by a falling stock price means a higher yield, which can fall after you buy in. Investors who chase past performance might be risking an encounter with this so-called value trap.

Another thing to consider: Taxes on dividend income could go up next year, significantly. Since 2003, "qualified" dividends have been taxed at a low 15 percent for folks in the 25 percent and 35 percent tax brackets. With the impending expiration of the so-called Bush tax cuts in December, the distinction between qualified dividends and ordinary income is to disappear, meaning higher taxes on dividends. How high depends on your tax bracket.

[See Making the Most of a Disappointing Retirement Nest Egg.]

So how can you pick a relatively safe investment that still generates some extra cash from dividends?

When shopping for income, "yield" isn't everything. "You can find higher-yielding funds that are using leverage," says Tom Roseen, research manager for data provider Lipper. "You need to be careful when looking at yield by itself."

Yield-focused strategies can have dangerous outcomes, if investors ignore other critical factors like fund diversification and overall returns. Morningstar analyst Tim Strauts notes that the popular Vanguard Dividend Appreciation ETF (VIG) has had a lower yield than PowerShares Hi-Yield Equity Dividend Achievers (PEY)—2.13 percent vs. 3.72 percent for the past 12 months—but a higher total return (1.84 percent vs. -5.18 percent for the past five years). Both reference dividend indexes, notes Strauts, but PEY is structured to pick the 50 highest-yielding NYSE or Nasdaq stocks that have increased dividends for 10 years running. That left PEY with a concentration in financial stocks, something VIG's construction avoided.

"That can be one of the risks with dividend funds," says Strauts. "They can load into particular sectors that happen to have higher yields. You might think you're buying a dividend fund, but what you're actually buying is a financial fund."