Beware These 6 Traps With Your Dividend Portfolio

Is it any wonder investors have been gravitating to dividend-paying stocks? Of course, there's the oft-cited statistic that dividends have composed roughly 40%-50% of the U.S. market's long-run return. (The variations have to do with the specific data sets and time periods being examined.) And current bond yields make stock dividends look even more tempting than usual: The yield on the S&P 500 is currently higher than that of the Barclays Aggregate Index, a phenomenon that has happened on just a few occasions over market history.

No doubt about it, dividend payers can and should be an important part of investors' portfolios. But even as focusing on dividend-paying stocks is a sensible strategy, doing so doesn't come without pitfalls. Here's a closer look at some of the most common ones investors should be aware of today, whether they're investing in individual dividend-paying stocks or mutual funds focused on dividends.

Pitfall 1: Not paying adequate attention to valuation. A juicy dividend yield can signal a stock is a good buy, which helps explain why dividends are a key first screen for many value investors. For example, let's say a company that was trading at $30 a share pays a $1 per-share dividend; its dividend yield is 3.3%. But if the share price drops to $20 and the company maintains its dividend of $1 a share, its dividend yield would spike to 5%.

But dividend payers have enjoyed a good run recently, in part because the income stream investors earn from bonds has slowed to a trickle. The net effect of increased demand for dividend payers is that not every stock with a tantalizing yield is attractively valued at this point. Of companies with Morningstar analyst coverage and dividend yields of more than 2%, for example, about 18% currently earn 4 or 5 stars; meanwhile, a higher percentage--roughly a fourth--of the companies with yields of zero currently earn 4 or 5 stars. And some dividend payers are quite overvalued at today's levels; 31% of companies with robust, 2% dividends currently earn 1 or 2 stars. That's not meant to be a blanket statement that dividend payers are expensive and should be avoided, but it does serve as a reminder that a company with a fat dividend yield is only attractive at the right price.

Pitfall 2: Not emphasizing low costs in the realm of managed products. Dividend investors don't just need to focus on price at the security-selection level; if they're buying some type of a dividend-focused managed product, such as a mutual fund or exchange-traded fund, overpaying can also be costly. That's because fund expenses are paid first from a fund's yield and then from its return. From a practical standpoint, that means that a high-cost fund or ETF must take extra risks to deliver a yield that's competitive with payouts of its cheaper competitors. That explains why Morningstar's favorite dividend-focused mutual funds and ETFs, both "yielders" and "growers" tend to be low-cost relative to their peers.

Pitfall 3: Not paying sufficient attention to tax treatment. If you own dividend-paying investments inside of a tax-sheltered wrapper such as an IRA or 401(k) and you're not yet taking withdrawals, you don't need to concern yourself with the tax ramifications of owning dividend-paying securities. Assuming you reinvest your dividends, you won't owe taxes on those dividends in the year in which you receive them. The taxes on dividend payers are an important consideration for people investing in taxable accounts, however. While dividend tax rates are currently low--in line with long-term capital gains rates--you can't defer dividend distributions in the same way you can with capital gains realization. Instead, you'll pay taxes on those dividend distributions in the year in which you receive them, regardless of whether you reinvest or spend the money. (You'll receive a step-up in your cost basis if you reinvest, as discussed here.)

Those payouts represent a loss of control from a tax standpoint, where the name of the game is usually to defer taxes for as long as you possibly can. Moreover, not every dividend rates as a qualified one, eligible for today's fairly low dividend tax rates; nonqualified dividends, such as those from REITs, are subject to ordinary income tax. Those levies can reduce otherwise-attractive yields. Investors should also be alert to the fact that many dividend-focused mutual funds are focused on delivering a robust yield on a pretax basis; in addition to owning some nonqualified dividend payers alongside their qualified dividends, such funds may own securities such as bonds, preferreds, and convertibles.

Pitfall 4: Not factoring in foreign-tax considerations. Even as tax-sheltered wrappers like IRAs can make sense for dividend payers, there's an important caveat for investors who own dividend-paying stocks from foreign-domiciled companies within their IRAs. U.S. investors in taxable accounts can take a tax credit for taxes paid on foreign-stock dividends, but that's not of use for investors in IRAs, as discussed in this article. Investors should always be careful to let investment considerations, rather than tax details, drive their allocation decisions. Moreover, the tax-deferred (or tax-free, in the case of Roth) growth that one gets from an IRA investment may more than make up for reductions from paying foreign income tax. Nonetheless, it's an issue to keep on your radar.

Pitfall 5: Using them to supplant bonds.

As interest rates have trended down, some income-minded investors, especially retirees, have emphasized dividend-paying stocks at the expense of bonds. That's reasonable--but only to a point. That's because the role of high-quality bonds in investors' portfolio is not so much as a return engine but as a shock absorber. When the economy and the equity market are trending down ("bad returns in bad times," as asset allocation guru Bill Bernstein puts it), high-quality bonds will lose less than stocks and may even gain in value. Dividend-paying stocks, meanwhile, may lose less than the broad equity market in times of duress, but they'll still incur losses. Thus, while it's not unreasonable for investors to steer a small share of their bond allocations to dividend-paying equities, making a wholesale swap will jack up the portfolio's volatility and risk level.

Pitfall 6: Underestimating their sensitivity to interest-rate changes. One of the reasons that dividend-paying stocks have performed well recently is that bonds have been such weak competition from a yield standpoint. But when interest rates trend up, bonds can give dividend payers a run for their money: Assuming equivalent yields, many income-focused investors would prefer to own a bond, which is further up in a company's capital structure and therefore safer in case of bankruptcy or forced liquidation, than a stock. Thus, it's not unusual for dividend-paying stocks, in particular, to feel a tremor when bond yields trend up. Alex Bryan, Morningstar's director of passive strategies research for North America, explored dividend yielders' historic sensitivity to interest-rate changes in this article.