Rules for safe dividend investing

In this prolonged low-interest-rate environment, nothing has captured the hearts and minds of investors more than dividend stocks. Roughly three-quarters of the stock market’s real return has historically come from dividends, so there’s validity to chasing yield. But some industry experts worry this near-obsessive focus on high-yield investment strategies is putting our nest eggs at risk because it ignores the basic tenets of proper portfolio construction. And when you combine that with a fragile economy, the outlook only worsens.

“Dividend stocks tend to be under-diversified and this leaves your portfolio exposed, particularly in a downturn,” explains Tom Bradley, CEO of Steadyhand. Don’t forget that Canadian companies with dividends are heavily concentrated in just a few sectors that make up 30% to 40% of our overall economy—namely utilities, banks and real estate. If these sectors get hit hard, says Bradley, expect slower earnings and lower returns.

Then there’s the distinct possibility of an interest rate hike, at which point businesses will start feeling the pressure. “When companies see profits drop, stock prices go down, and so do your dividends,” Bradley points out.

Interest rate shock will also have a significant impact on home owners, adds Dan Werner, a Canadian bank analyst with Morningstar. “Mortgage holders will need to pay more to meet their debt obligations,” and if this results in an uptick in foreclosures or a decrease in the number of Canadians who can afford to buy a house, expect that to have a big impact on the banking sector’s bottom line.

So what can dividend lovers do to protect themselves? Minimize their portfolios’ exposure to volatility and risk. That means making sure your investments are broadly diversified, not just by geographic region or asset class but by return type: Does your portfolio provide dividends, capital gains and interest income—the three types of earnings that make up total return?

If you’re too heavy in dividends, it’s time to rebalance. If it feels scary slashing the amount of dividend cheques you receive, says Bradley, take heart: “This portfolio approach will actually provide you with a better overall return.”