Having an investment portfolio chock full of dividend-paying stocks can provide an income boost, but experts say it's possible to have too much of a good thing.
“If you buy a business that's declining and paying you a good dividend, that does not help you,” said Matt Manara, executive vice-president and portfolio manager at Avenue Investment Management.
Typically, investors will screen stocks for yield in a lower interest rate environment, Manara said, since savings accounts and fixed-income investments like Guaranteed Investment Certificates have meagre returns in that scenario — it pushes investors to hunt for yield in the stock market.
But just because a company has a high dividend yield, it doesn’t necessary mean it’s a good investment.
“Scanning for yield and getting above-market yields and just using that as the criteria to search for a company is a flawed methodology and can lead to large portfolio losses,” Manara said.
“The market is signalling something might be wrong,” he said. If the high yield comes because the share price is falling, that could be a sign that the company’s cash flow is declining, it has a lot of debt, it’s having to issue more shares or the stock is in an out-of-favour sector.
However, there are situations where tilting your portfolio toward dividend-paying stocks makes sense, such as for retirees who want a steady income stream in their golden years.
Having that consistent income can also remove some of the stress that comes with market volatility, said Megan Sutherland, senior investment adviser at BMO Nesbitt Burns.
For many of her clients who are retirees, having a portfolio that generates cash flow regardless if the market fluctuates can “remove that emotional reaction to the markets because you know that your portfolio is paying you.”
Sutherland acknowledges though that only investing in dividend stocks can expose you to concentration risk.
The tech downturn in 2022 is a good example of that, she said. Tech stocks soared during the pandemic as people increasingly turned online to shop, communicate, work and for entertainment. As life returned to normal post-pandemic, the tech sector took a dive, and investors who had put too much of their money in tech saw their portfolios sink.
That lack of diversification can also play out if your portfolio is concentrated in sectors and companies that typically pay higher dividends.
“If you think about telecoms, utilities, real estate — those are going to be really interest-rate sensitive, so if we're seeing interest rates go up and you have all your money invested in those sectors, you could see a bigger downturn in your portfolio than if you were diversified,” she said.
It’s about finding that “sweet spot,” she said.
“Finding those companies, those gems that pay good dividends, that are good businesses that you can potentially get the growth of the common shares, but you're also getting that cash flow.”
Manara agrees that dividend payers can provide solid income for retirees but “that doesn’t mean you can buy bad businesses.”
His preferred metric for assessing stocks is return on capital, a profitability measure which gauges how effectively a company can turn capital into profit.
“It always comes back to is the dividend sustainable, is the company earning high returns on capital and able to have money to reinvest in themselves and pay somewhat of a dividend," he said.
"And the general rule of thumb is if you’re getting above-market yields, chances are that you might be going way up the risk curve because you’re buying a business that’s fundamentally broken.”
He said the majority of the return on an equity investment is capital appreciation from the stock rising, and the compounding effect of reinvesting the dividend.
“It's very misleading, where some dividend investors feel you just take the dividend, strip out the dividend, and you don't reinvest the proceeds ... it doesn't have the same compounding effect if you're just taking the money out and using it to fund your lifestyle cost or spending the money,” Manara said.
While markets are down or trading sideways, Sutherland says generating that cash flow and reinvesting dividend payouts can lower the average cost per share to better position you for a market upswing.
“So it does give you a little bit of optionality in terms of what to do versus just a growth stock that doesn't pay anything,” she said. “You're essentially getting paid to wait."
This report by The Canadian Press was first published March 13, 2025.
Michelle Zadikian, The Canadian Press
