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Why invest in stocks with a high-dividend yield?

(MoneyWatch) Investing in stocks that pay relatively high dividends has become so popular that the SPDR S&P Dividend ETF (SDY) now has more than $12 billion in assets and the iShares High Dividend Equity ETF (HDV) has well over $4 billion.

Given the low level of interest rates available on safe bonds, it's understandable why a high-dividend strategy might have appeal. However, in prior posts we have shown that not only does using a high-dividend strategy as a substitute for safe bonds entail great risk, but also that a high-dividend strategy is really just a weak value strategy.

Given the continued popularity of the strategy, I asked my colleague and "Right Financial Plan" co-author Kevin Grogan to update the data to demonstrate this point. For the period July 1951 to December 2012, a high-dividend strategy returned 12.7 percent, which looks good compared to the return of 10.7 percent for the total U.S. stock market. However, when we compare the results to those of three other value strategies, we see a very different picture.

We also know that high valuations predict low future returns. When we look at the various valuation metrics for SDY and compare them to those of the Vanguard Value Index Fund (VIVAX), we find that:

  • VIVAX has a price-to-earnings ratio of 11.8, while SDY is at 16.5.
  • VIVAX's book-to-market ratio is 1.5, while SDY's is 2.6.
  • The price-to-cash-flow ratio is 5.6 for VIVAX and 9.0 for SDY.

Thus, we should expect it to provide lower returns in the future.

Here are some other important facts:

  • High-dividend strategies concentrate risk. For example, SDY holds only 60 stocks. Thus it's not as well diversified as other value strategies, which typically will own hundreds of stocks.
  • The risks of high-dividend strategies tend to surface at the wrong time: when stocks are doing poorly. For example, high-dividend stocks lost nearly 40 percent over the fourth quarter of 2008 and the first quarter of 2009. On the other hand, five-year Treasury bonds provided a total return of almost 7 percent over the same period.

The bottom line is that while a high-dividend strategy has produced superior results relative to the overall stock market, other value strategies have produced even stronger returns. Thus we can consider a high-dividend strategy a poor man's value strategy, not a substitute for safe bonds. If you have made that mistake, you don't have to keep making it.

Image courtesy of Flickr user 401(K) 2013

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