High-yield dividend-paying stocks used to be seen as risky investments.
That was before the economic downturn exposed other risks in the financial system that could be just as damaging, such as the heightened risk of inflation due to the rising cost of food and energy.
These days the average rate for a one-year bank CD has fallen to around 1 percent, whereas many of the dividend stocks listed on the S&P 500 are yielding at least 5 percent.
While dividend-paying stocks can be a great way to get a better payout than would be available in CDs or government bonds, there are pitfalls that come with investing for higher returns in the stock market.
"The underlying problem any time you invest in a stock is the price can go down even due to a short-term event such as fear," said Nancy Skeans, a partner at Schneider Downs Wealth Management.
"The search for income is driving people to look more at equities because they just aren't getting it from bonds, money market accounts or CDs because interest rates are so low," she said.
>Few high-yield options
Corporations declare dividends to distribute a portion of the company's profits to shareholders.
Like it or not, dividend stocks may be one of the few high-yield alternatives for the foreseeable future.
Federal Reserve Chairman Ben Bernanke has said that cash will likely yield close to zero percent interest until 2014. Although stock prices are not insured by the Federal Deposit Insurance Corp., stocks with solid dividend payments do offer some downside protection during times of volatility.
"High-quality companies not only offer attractive yields relative to cash, but also have the potential to grow their dividends over time, which should help keep up with inflation," said George Emanuele, a vice president and investment adviser at PNC Wealth Management.
"Not only do dividend-paying equities offer an attractive income stream," he said, "but since 1926, dividends have accounted for approximately 44 percent of total return and dividend payers have outperformed non-dividend payers."
Some of the more well-established companies that are paying dividends higher than bank CD rates are Johnson & Johnson (JNJ) with a current dividend of 3.5 percent; Verizon (VZ) at 5.3 percent; and Bristol-Meyers Squibb Co. (BMY) at 4.2 percent.
Nate Snyder, a partner and portfolio manager at Snow Capital Management, a $3.5 billion investment firm based in Sewickley, Pa., said he sees some strong dividend opportunities right now, but he also sees a lot of overpriced stocks as well.
It makes him cautious, and he warns investors not to jump in head first.
"What's happening in high-yield stocks is not dissimilar to what is happening in the bond market in general," Snyder said. "People are paying extraordinarily high prices, which is driving down yield.
"It's an indication of how insatiable the demand is now for perceived lower-risk assets."
With the annual yield on a 10-year U.S. Treasury note at 1.89 percent, savers stand to lose purchasing power on every dollar held in a bank account even if inflation rises at a modest 2 percent each year.
But dividend stocks offer no guarantees. A high-dividend payout could be due to a declining stock price. A company's board of directors may even decide to either cut or eliminate quarterly dividends altogether if times are tough and profits begin to slide.
"People become so focused on the fact that the security is paying a dividend that they forget about the risk associated with the security itself," said Andrew Stoltmann, a Chicago-based securities lawyer.
He said he handled more than a dozen FINRA arbitration cases after the 2000-02 market crash where clients sued their financial advisers because of recommendations for stocks that were paying fat dividends. FINRA, or Financial Industry Regulatory Authority, is a nongovernment group that polices the securities industry.
"They received those dividends," Mr. Stoltmann said. "But unfortunately the stock itself lost 80 percent or more of its value."
>Know risk tolerance
Bob Fragasso, chairman and CEO of Fragasso Financial Advisors, said the key to an individual deciding if dividend stocks are the right way to achieve a higher return is to determine one's personal objectives.
"People make the mistake of focusing on the details of the investment rather than their own risk tolerance and time frame," Mr. Fragasso said.
They also only focus on one aspect of the investment -- the yield -- while forgetting their principal will fluctuate.
"If I have money I'll need in a year or two, I know the principal should remain intact," Mr. Fragasso said. "That means I should keep it in a money market fund".
"But if I have investment money where the fixed income yield is too low, I should definitely look into dividend stocks. Because my perspective is longer, I can ride through the volatility."