Pros and cons of investing in dividend stocks in a bear market

Investing in dividend stocks during a bear market may reward patient investors with long-term profits.

  • By Barbara Friedberg,
  • U.S. News & World Report
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Investing in dividend stocks is widely considered to be a "can't-miss" way to build wealth and receive a steady income stream.

"A company's dividend policy can be a testament to the company's confidence in future earnings growth and sustainability," says KC Mathews, chief Investment officer at UMB Bank in Kansas City, Missouri. "A clear sign of confidence a management team can send to investors is to grow its dividend."

When you receive a dividend payment from a stock that you own, the company has decided that you as a shareholder will benefit more by receiving a portion of the firm's net income than the firm would gain by reinvesting that money back into the company. That's the reason fast-growing smaller companies typically reinvest profits back into the company and older firms with fewer growth opportunities are more likely to pay dividends.

If you're a buy-and-hold kind of investor, dividend stocks can reward you with profits over the long term. That said, in today's market, this strategy might not work for everyone.

Before you invest in dividend stocks, here are a few things to do:

  • Understand the power of reinvested dividends.
  • Recognize the pitfalls of buying in a volatile market.
  • Look at the long-term economic picture.

Understand the power of reinvested dividends

A recent study by Hartford Funds illustrates the important role dividends play in the S&P 500's returns. From 1970 through 2019, 78% of the total return of the index can be attributed to reinvested dividends and the power of compounding. According to the study, $10,000 invested in the S&P 500 in 1970 – with dividends reinvested – would have grown to $1,636,370 by 2019. When disregarding dividends and only considering price appreciation, the $10,000 initial investment in the index increases to just $350,144.

When you invest during a bear market in a solid company with a history of increasing its dividend payments, you obtain a degree of comfort that you'll receive cash flow while you own that stock. Even if the shares lose value during a bear market, you'll receive income from your dividends.

For long-term investors, "A bear market is your best friend because you can pick up quality companies with higher yields," says Marc Lichtenfeld, chief income strategist at The Oxford Club and author of "Get Rich With Dividends."

"Reinvesting those dividends during the down market allows you to buy more shares at lower prices and ultimately puts the compound return machine into overdrive," he adds.

Current interest rates are extraordinarily low, which hurts investors seeking yield on their investments. Bonds historically earned a 5% return, so an investor with a $100,000 portfolio could comfortably earn $5,000 cash flow each year. Today, investors are lucky if they receive 1% to 2% returns on their fixed investments.

"Given the historically low current interest rate environment, I would encourage investors to consider substituting high-yielding stocks for bonds in a portfolio," says Robert R. Johnson, professor of finance at Heider College of Business, Creighton University. Dividend aristocrats are companies in the S&P that have increased their dividend payouts for at least 25 consecutive years. Examples include stocks of Johnson & Johnson (JNJ) and Walmart (WMT).

The advantage to investing in dividend-paying stocks over bonds is that dividends typically increase over time, and the stock price of these firms may also appreciate. "With bonds, the holder only receives the promised interest payment and principal back," Johnson says.

Recognize the pitfalls of buying in a volatile market

Investing in a bear market comes with its own set of risks.

Equity investing is volatile in general, but stock market price swings ramp up during a bear market. Only long-term investors should invest in the stock market because, in the short term, stock prices are unpredictable. Additionally, there are specific risks to dividend investing.

Limiting yourself to dividend-paying stocks eliminates many excellent companies from your portfolio, says John Madison, CPA and financial counselor at Dayspring Financial Ministry in Ashland, Virginia. Specifically, Warren Buffett's Berkshire Hathaway (BRK/B) shares have never paid a dividend. Madison reminds shareholders that dividends are not free money but are paid out of the share value of the stock.

Beware of stocks offering ultra-high dividend payments. This dividend yield trap might indicate corporate trouble as the stock price falls faster than dividend cuts, Mathews says. Stocks with outsize dividend payments might reflect poor earnings growth and excess debt, which will lead to declining stock prices and investment losses.

Today's bear market is reflective of a global slowdown triggered by the spread of the COVID-19 pandemic. This is impacting global trade and will severely damage corporate profits this year. During a recession, dividend cuts or eliminations are an investor's enemy and represent a reduction in income and loss of capital as the stock price declines, says Benjamin C. Halliburton, chief investment officer at Tradition Asset Management.

Look at the long-term economic picture

At present, companies are experiencing unprecedented declines in revenues and profits. This will negatively impact many companies' shares, including the dividend payers. Financial experts have suggested that it may take up to five years for the economy to return to normal – meaning some companies might never bounce back from the current economic downturn.

Investors seeking shelter during the bear market storm won't find a perfect solution to handle volatile financial asset prices in dividend stocks. Still, investing in dividend stocks during a bear market can be a successful strategy for long-term investors with cash on the sidelines.

For successful dividend stock investing, choose high-quality companies, don't chase dividend yields and consider investing in a diversified dividend aristocrat fund like the SPDR S&P Dividend ETF (SDY). By choosing a fund over individual stocks, you'll spread out the risk of picking the wrong stock.

During uncertain economic times like today, it's wise to invest thoughtfully. Dividend stock investing during a bear market may reward patient shareholders with long-term profits.

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