In a Crazy Stock Market, Dividends Aren’t Your Friend

NEW YORK (MainStreet) -- With interest-bearing accounts paying practically nothing and bonds paying little more, many income-oriented investors are turning to dividend-paying stocks. But a fresh look at the numbers shows investors tread this path at their peril.

“More than $18 billion has poured into the Lipper Equity Income category .... through September 2011, the largest amount of cash flow of any Lipper equity fund category year to date,” the Vanguard Group reported earlier this week. “This seems to suggest investors may be looking beyond bonds in search of income.”

The Lipper Equity Income category includes mutual funds and stocks that, as the name suggests, try to maximize strong, steady income, primarily from dividend-paying stocks.

While there are many good investments in this category, Vanguard Chief Economist Joe Davis warns in a blog post that high risks make dividends an overly risky substitute for investments that pay interest. In the term “dividend-paying stocks,” the key word is “stocks.”

The issue can be clearly seen by looking at some standard measures. From Dec. 31, 1997 through Oct. 31, 2011, the average annual return of U.S. stocks was 4.2%, versus 5.7% for the dividend-paying stocks in the group, and 6.1% for bonds. In other words, bonds did better. Yields, or annual income from dividends or interest earnings, were 2.2% for all stocks, 3.7% for dividend stocks and 2.3% for bonds. Return adds interest or dividend earnings to the investment’s price changes, up or down.

It’s important to note that stocks had an unusually bad run during this period, thanks to the dot-com collapse and financial crisis, while bonds enjoyed rising prices as falling interest rates made older, more generous bonds more attractive. Today, there’s no guarantee bonds will continue to do so well, since rates are now very low and more likely to rise than fall, causing bond prices to drop in coming years.