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We all like high dividend paying stocks. Who doesn’t?

Studies show that high dividend paying stocks outperform S&P500 in the long term but one should avoid these rookie mistakes:

1. Buying a stock that has totally crashed in stock price that results in a high “dividend yield.

Example: Company A that has serious problems announces that next quarter profits and has to make som writeoffs will probably go down in stock price. The dividend yield however increases as the stock price declines because the company hasn’t slashed its dividend yet. A random investor buys the stock with a dividend yield of 10% at that moment. One week later the company announces that dividend will be suspended.

This happened to many financial stocks during the storm of the financial crisis. The majority of them cut their dividends and went further south. Anyone who thought about high dividend investing during that period would have lost a substanial amount of money.

A good example of a high dividend stock that declined in price thus yielding very high and later got its divdend suspended is Capital Trust.

Capital Trust was a typical pseudo - high dividend paying stock.

2. A moderate company with no growth prospects. The company hasn’t raised the dividend in the last 10 years but the dividend yield is higher than average. In my book it’s still a stock to avoid. A company that doesn’t grow nor raises its dividend will probably not beat the major indexes over the long term.

I rather buy a company with a future and a dividend below average that is growing with more than 10% a year.  It’s also a known fact that dividend growers beat the general stock indexes over the long term. The dividend growth is another discussion.

There has been numerous studies that has come to the same conclusion: A basket of high dividend blue chip stocks beats indexes like dow jones, S&P 500 etc. I’ve read a swedish university study on this case. The interesting thing I noted it’s the same thing here. High dividend paying stocks on the swedish stock exchange beat the genereal index OMX over a ten year period, 1995-2005. Is this a global phenomenon?

When I read the swedish study I found a few interesting facts. The reason why the high paying dividends stocks beat the index is because high paying dividend stocks are usually cheap stocks at the time they are paying high dividend relatively to their stock price. I’m going to talk about third variable effects here people. There has been another study showing that a basket of stocks that has suffered from heavy declines usually outperforms the market the following year. Yes, think about that, 20 blue chip companies that pays dividend and all of them suffers from heavy decline in stock price. What status do they achieve? That’s right HIGH DIVIDEND PAYING STOCK ( given the fact that they don’t slash dividends ).  Back to the high paying dividend stock studies, when the stocks were bought it was usually stocks that had suffered from heavy decline in stock price but hadn’t slashed its dividend, thus becoming high dividend paying stocks.

Why buying high dividend paying stocks might not be a market beating strategy. I’m a going to disappoint my readers here. The number one reason is the market is very effective of absoring information and numbers making it hard to see leaks to outperform the market in the future. Yes folks I’m talking about the effective market hypothesis. If all the information about high paying dividends stocks beating the index, in example dogs of dow being a better investment than just to invest in dow jones won’t the demand for dividend stocks drive the prices up and making it harder to beat the index. It’s easy to backtest and find strategies that outperform the market but this high dividend paying stocks strategy might as well stopped working because many more people are dividend investors and this might lead to finding good high dividend paying stocks tougher.