Overview: During bear markets, investors frequently look to other strategies that could bolster their portfolios. Some will consider purchasing dividend-paying stocks to offset their market losses. However, dividend investing not only increases the risk in a portfolio but has also been unable to escape the effects of the recession.
 

Dividend-investing proponents argue that dividend payments can help offset losses in a bear market and provide a steady source of income. However, the bear market of 2008–2009 has already caused a number of steady dividend-paying companies to cut or eliminate their dividend payouts. A March 20, 2009 CNNMoney.com article said the number of companies cutting dividends reached 46 in just the past six months, compared to only 17 companies in all of 2007. The article also reported that recent dividend payments have been cut by 50 to 80 percent. Standard & Poor’s has estimated that dividend payments will fall by 22.6 percent this year, the largest decline since a 36.3 percent drop in 1938.

 

Another risk involved in purchasing individual stocks for dividend income is the increase in unsystematic and uncompensated risk in a portfolio. By holding concentrated positions in individual stocks, a portfolio is no longer well diversified, and the portfolio’s risk and volatility multiplies. In fact, a 2002 study found that the optimal level of diversification (measured by the rules of mean-variance portfolio theory) requires holding at least 120 individual stocks. Achieving that diversification would require additional trading costs and additional time to search for 120 dividend stocks to purchase.

 

Recent dividend cuts have affected every sector, and share prices have also been hit across the board. Dividend investors often suggest investing in noncyclical, “safe” sectors — such as consumer goods, utilities and pharmaceuticals — to ensure strong dividend stocks. But this market has not shielded these sectors:

Dividend investors have seen cut dividend payments, falling share prices and much higher risk in their portfolios during this market. Dividend yields have increased recently, but investors must be careful not to confuse yield with return when looking to increase expected returns in a portfolio. The higher yields reported by many stocks are most likely due to a drop in share price. Higher yields due to lower prices signal a riskier stock as the market has reduced the stock price to reflect its valuation of the company.

 

Dividends are not guaranteed, and companies can generally choose to suspend or lower their dividends at any time. Relying on individual stocks that pay dividend income as an investment strategy adds a significant amount of risk to a portfolio. Investors should also remember that yields do not equal returns, and that high yields are often indicative of risky stocks. Finally, a study by Ken French (and reconfirmed in a 2008 paper published by DFA) showed that dividend-to-price ratio is a poor predictor for expected returns. In fact, out of four fundamental ratios — including book-to-market, earnings/price, cash-flow/price and dividend/price — the dividend/price ratio was the least statistically significant as an indicator of the value premium for stocks.