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Investing Specialists

Two Keys to Avoiding Dividend Cuts

Love your dividends, but don't reach for yield.

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With interest rates on bank CDs, Treasury bonds, and other minimal-risk investments being very low, I can understand the almost visceral appeal of a stock carrying a yield of 10%, 12%, or even 15%. Those who rely on their portfolios to pay the bills would probably find that extra income awfully handy. But I've noticed a troubling pattern--both in my three-plus years of editing Morningstar DividendInvestor and my 18 years as an individual investor: Sky-high yields are a warning sign. As attractive as a double-digit yield might seem, what you see today might not be what you get for much longer.

This is no small risk for investors, whether they're relying on the income to pay their bills or not. Take  National City (NCC), for example. At the end of December, the stock appeared to carry a 10% yield. To someone starved for income on bank CDs, the firm's common stock might have seemed to offer a much better prospect. But that yield didn't last long--on Jan. 2, National City cut its quarterly dividend from $0.41 a share to $0.21. Three months later, the bank declared a dividend of just one cent a share. An investor who bought 100 shares of National City for $1,646 could have originally expected $164 worth of annualized income. He or she now stands to get just $4. And not only did that income stream all but vanish, but the stock price got clobbered--recently National City shares have been trading for about $6.

Picking winners is good, but much of an investor's overall success depends on avoiding losers like National City. Fortunately, dividend cuts can be avoided. The two most critical keys in this regard are know what you own, and listen to the market.

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Josh Peters, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.