Dividend stocks: Buyer bewareJanuary 31, 2012: 5:00 AM ET
With bonds, CDs, and money markets offering paltry payouts, it's no wonder investors are looking for better returns. They just need to know what they're getting into.
FORTUNE -- There's one group of people who aren't cheering Ben Bernanke's announcement last week that the Federal Reserve expects to keep interest rates ultra-low through 2014: people of modest means who live off their interest income.
As I've been pointing out since 2007, the Fed has eviscerated the income of prudent savers in its attempt to repair the economic damage caused by imprudent borrowers and lenders. I believe that the Fed, whose job is to protect the financial system and promote employment, is acting in the best interests of the country at large. But what's helping the overall economy is hurting savers.
The people with the biggest problem are those who saved all their lives and are now supplementing their Social Security retirement checks with interest income. With that income cut sharply -- five-year Treasuries yield less than 1%, and yields on certificates of deposit are microscopic -- these people have three options, all of them unpleasant: reducing their standard of living as their income drops; eating into their principal; or taking on more risk in order to generate more income.
Risk has become a popular option, which helps explain why dividend-paying stocks are in vogue. Last year, the dividend-paying stocks in the Standard & Poor's 500 returned 5.3% more than non-dividend payers, according to Aronson Johnson Ortiz, a Philadelphia money management firm. That's a sharp reversal from 2010 and 2009, when non-dividend payers outperformed by 1.6% and 35.6%, respectively.
Part of the reason for last year's outperformance, I'm sure, comes from lots of money, including a chunk of mine, being plowed into dividend-paying stocks because bonds and CDs yield so little, and you need an electron microscope to find the yield on money market mutual funds (my main money fund's current yield: a whopping 0.01%).
Recommending dividend stocks has become the conventional investment wisdom, and understandably so. However, if you're joining the dividend-seeking hordes, you need to realize that you're taking a much bigger risk than owning CDs or bonds.
CDs are guaranteed by the federal government. Bondholders are first in line to get paid, and ultimately get their principal back if the issuer doesn't default. But a dividend-paying stock is a whole other story.
Common shareholders are the last in line to get paid, not the first. As many bank stockholders discovered to their sorrow when the financial crisis struck, dividends can be cut sharply or even eliminated if a company runs into trouble, or needs to conserve capital.
In addition to income risk, stockholders have price risk, too. They have no guarantee of getting back the price they paid for the stock. If a stock's annual dividend is, say, 3% of its market price the day you buy it, a hiccup or two can wipe out several years of interest income.
"While a dividend-paying stock can feel like a bond, at some point market volatility will slap you with a painful reminder that it's not," says Stefani Cranston of Aronson Johnson Ortiz. "And, if 2011 was any indication, one thing you can count on is market volatility."
The bottom line: If you go the dividend route, which is what I've done because I'm 67 and may not be employed full-time forever, make sure you understand what you're getting into. Make sure you can afford the losses if you pick some wrong stocks or wrong mutual funds, which even the most astute investor does occasionally. Yes, a 3% dividend yield is vastly more attractive than a 1% interest yield. But remember that the added income comes with greater risk. It's the one economic rule that never changes: There's no such thing as a free lunch.