“More money has been lost reaching for yield than at the point of a gun.“
— Raymond DeVoe Jr.
I’m thankful that getting robbed at gunpoint is something I’ve never experienced.
It’s one of those traumatic experiences that result in spending years on a psychiatrist’s couch.
But I have made the mistake that so many income investors make.
I reached for yield … and got burned.
However, you can learn from my mistake. Here’s how.
Devoe and Buffett’s Yield Lessons
You might not know of Raymond DeVoe Jr.
He was an influential and colorful newsletter writer who passed away in 2014 at the ripe age of 85.
Oh, and he was also a card-playing buddy of Warren Buffett’s.
For the market trivia buffs out there, he was the one who coined the phrase “dead-cat bounce” to describe a short-lived market recovery.
In an interview in 1986, he said: “If you threw a dead cat off a 50-story building, it might bounce when it hit the sidewalk. But don’t confuse that bounce with renewed life. It is still a dead cat.”
DeVoe was nothing if not quotable throughout his career.
But his quote on reaching for dividend yield is pure genius.
His buddy Warren Buffett put it in even more blunt terms during a CNBC interview back in 2020: “Reaching for yield is really stupid, but it’s very human.”
Let’s talk about that.
2 Risks of Reaching for Dividend Yield
Though a little higher these days, bond yields have been low for the better part of 20 years now.
In 2000, the 10-year Treasury bond yielded 6.6%.
By 2003, at the end of the tech bust, the yield had dropped to 3.3%.
And then, following the 2008 meltdown, yields collapsed again and continued to fall until bottoming out at 0.5% in 2020.
As I write this, the 10-year Treasury’s yield is about 3.3%.
That’s better than 0.5%.
But it’s nowhere near enough to keep up with inflation.
And yields in most traditional savings products, such as certificates of deposit (CDs) or savings accounts, are much lower.
The average savings account yield today is a pathetic 0.13%.
In an environment like this, getting excited is normal when you see a yield of 8%, 10% or even higher.
But while on occasion, you can find a great opportunity in an ultra-high yielder, a super high dividend can mean one of two things:
- The company expects the dividend to be the only source of return, so investors should not anticipate much in the way of capital gains.
- The dividend is at serious risk of getting cut, and the market has already priced the stock accordingly.
Let’s take a closer look.
Dividend Yield: The Lone Source of Return
The first category is not all bad if you understand this going into the trade.
Mortgage real estate investment trusts (REITs) and certain types of closed-end funds fit that description.
For example, Annaly Capital Management (NYSE: NLY), one of the largest and best-respected mortgage REITs, yields 13.7% today.
But the share price, at $6.50, is barely half its 1997 IPO price of $11.94.
And the dividend, while high, is by no means stable.
Annaly has raised and lowered its dividend plenty of times over the years.
Now, does this mean you should never own a mortgage REIT like Annaly?
Of course not.
You might have room in your portfolio for a small allocation to a monster yielder like this when the timing is right.
But you do not want to weigh down your portfolio with something this unstable.
And then we have that second risk: high yields that precede a dividend cut.
Risk of Dividend Cuts
This is where investors tend to get in trouble.
And as a morality tale, let me share my own experience here.
I will go to my grave cursing Thornburg Mortgage.
Back in 2008, a younger, cockier version of myself thought I had discovered a “can’t lose” investment because it had a yield over 10% at the time and an “unassailable” portfolio of superprime jumbo mortgages. (That’s superprime, i.e., better than prime, not subprime.)
Of course, that 10% yield didn’t get me far when the financial crisis wrecked the mortgage market, and the company had to file for bankruptcy.
That is the only time I’ve lost 100% of my money in an investment.
So if reaching for dividend yield is bad, what is the right way to invest for income?
3 Rules: Invest for Income the Right Way
Here are three rules I’ve put together from the harsh mistress of experience.
- Focus on companies paying a moderately high yield.
These days, I’d define that as 3% to 7%.
We can and do find regular higher-yielders worth buying.
But they’re the exception, not the rule. Your safe range is 3% to 7%.
- You need a growing, healthy business to support that dividend.
Remember, dividends are distributions of profit.
You need stable and growing profits to make the dividend possible.
So avoid companies that have fallen on hard times.
They almost never work out as dividend plays.
- Look for consistent dividend growth.
A company doesn’t have to raise its dividend yearly, but you want to see a long-term trend of consistent dividend hikes.
If this is a stock you intend to hold throughout your retirement, consistent dividend growth will be the only thing that keeps you ahead of inflation.
And speaking of dividends … my and Chief Investment Strategist Adam O’Dell’s upcoming issue of our premium research newsletter Green Zone Fortunes features one of my favorite long-term cash machines.
To find out more about how we seek to help you adapt and profit in any market, click here for details on how to join Green Zone Fortunes — and you’ll be first in line to get the September issue, due out next week.
Until next time…
To safe profits,
Charles Sizemore, Co-Editor, Green Zone Fortunes
Charles Sizemore is the co-editor of Green Zone Fortunes and specializes in income and retirement topics. He is also a frequent guest on CNBC, Bloomberg and Fox Business.