Risk And Investing For Income

Last time, I talked about calculating yields for stocks and how that figure can be used to compare differing investments. If you recall, we looked at three different investments:

• A typical savings account paying 1% or less
• Realty Income stock (O) paying 4.58%
• Microsoft stock (MSFT) paying 2.95%

If we just look at the yields, it looks like the obvious choice is Realty Income. But this overlooks one important factor: risk.

How Safe Do You Want To Be

Investing in stocks always involves risk. Stock prices change each second the market is open. Because a stock's dividend yield is determined by the stock price, this means their yield is also changing by the second. The calculation of a stock's dividend yield is:

As you can see, two factors can cause the yield to change. If the dividend paid out is increased or decreased, the yield will increase or decrease. However, because the share price is the divisor of the yield calculation, it has an inverse relationship with the yield. If the share price goes up, the yield goes down. If the price goes down, the yield goes up. Both the price and dividend can change at any time. A company can reduce or even completely eliminate its dividend. The company can also go bankrupt, reducing it's stock price to zero. This is why stocks have risk.

A savings account however, is pretty much risk free. Assuming you are banking at an institution that has some sort of government insurance, your principle is guaranteed to never lose value by either the FDIC (for banks) or the NCUSIF (for credit unions). Obviously, this safety comes at a price - a lower yield.

Don't Chase High Yielding Stocks

It may be tempting to search for stocks that have a high dividend yield. If that is all you are looking at, you can get in trouble. For example, I used Yahoo's stock screener to look for stocks that have a dividend yield of at least 20%. The top result returned was Atlas Resource Partners, with a dividend yield of 43.5%!

Click to embiggen

But before you put all your funds into this stock, look a little closer. The yield is so high because the yearly dividend is $1.30 and the share price is only $2.99. And see that EPS number? That stands for Earnings Per Share. That number is negative, which means the company is losing money - it's losing $6.53 per share. Basic common sense should tell you that the dividend is likely going to be reduced or cancelled altogether very soon. If the company is losing $6.53 per share, how long can it afford to pay out $1.30 in cash to investors each year? In fact, the company itself could go under.

When you screen for stocks based solely on dividend yield, you may end up with a bunch of penny stocks that no serious investor should buy.

Next week, I'll go over what I look for when buying a stock for dividends.