Danger in dividend yields

A high dividend yield can indicate there's value in a stock, but there are plenty of traps for the unwitting investor.

If you're anything like us, you probably enjoy running your eye down the dividend yield column of your favourite financial pages. As far as yardsticks for value go, a high dividend yield is one of the most straightforward. Unfortunately, simplicity doesn't equate to reliability and many investors end up buying high-yielding stocks that turn out to be absolute dogs.

It's a topic we discussed in our More to income than yield article of issue 136/Sep 03, which we recommend reviewing. In this article we're going to suggest some specific questions you might like to ask next time a stock with a high yield jumps off the page at you.

First and foremost

The first and most important question is: 'Do I understand exactly what this investment is?' This gets back to the words Ben Graham wrote in chapter 20 of our namesake, The Intelligent Investor: 'Investment is most intelligent when it is most businesslike.'

Many people shop around to save a few hundred dollars on their whitegoods, or even a few cents per litre on the price of petrol, but then invest thousands of dollars after minimal research and only a few minutes of thought. We suspect the problem is that a lot of people don't know where to begin, so they take a deep breath, place the buy order and hope for the best. If you take the following pledge, we guarantee your investing results will improve:

From this day forward I shall never place a single dollar in an investment which I do not understand. I will undertake any required research and not be afraid to ask 'silly' questions of anyone who has recommended a stock or product to me until such time as I am comfortable with the nature of the investment and the risk it entails.