A history of paying dividends is one of the strongest endorsements a stock can have, but dividend stock investing can harbour hidden dangers.

We’ve always placed a high value on dividend stock investing, mainly because it provides something of a pedigree for stocks we recommend. After all, you can’t fake a record of dividends.

It takes a lot of success and high-quality management for a company to have the cash and the determination to declare and pay a dividend every year for five or 10 years or more. It’s not something you can create on the spur of the moment.

Now many investors have come to share our high regard for dividend stock investing, especially as a source of retirement income. However, some take this reliance on dividend stocks to extremes. They put too much faith in a history of dividend payments. They think of a stock with a good dividend history as the next best thing to a government bond.

But it’s nothing of the kind. It’s a good sign, but not the only sign you need to consider. It takes continuing effort to succeed as a so-called “buy-and-hold” investor. You need to learn how to “buy and watch carefully.”

Here’s the biggest risk with high dividend yields

When looking for high dividend stocks, you should avoid the temptation of “reaching for yield.” That is, choosing investments purely because they offer a high current yield.

That’s because a high yield may signal danger rather than a bargain, if it reflects widespread investor skepticism that a company can keep paying its current dividend.

Dividend cuts always undermine investor confidence, and can quickly push down a company’s stock price.

How to spot the highest-quality dividend-paying stocks

As we mentioned, we think investors will profit most—and with the least risk—by buying shares of well-established, dividend-paying stocks with strong business prospects.

The best firms also have rising sales and profits and sound balance sheets, as well as a strong hold on a growing market. Additionally, they have strong management that will make the right moves to remain competitive in a changing marketplace.

Those are the kinds of stocks we recommend in our newsletters and investment services.

Use 3 portfolio rules to avoid the danger of dividends at risk

Even the best dividend stocks can go through dividend droughts—periods when they have to cut or quit paying dividends due to setbacks within their company, their industry or the economy as a whole.

That’s why you still need to observe our three key portfolio rules. They are:

1. Invest mainly in well-established companies.
2. Spread your money out across most if not all of the five economic sectors (Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities). This cuts your risk of getting too heavily invested in an industry or sector that is headed for a slump. It also increases your chances of investing in a super stock with returns that are two to five times or more higher than the market averages.
3. Downplay or avoid stocks that are in the broker/media limelight. This limelight inflates investor expectations. When stocks fail to live up to those inflated expectations, downturns can be brutal.

Just remember that if you place too high a value on any single investment attribute, like dividends, you may overlook signs of associated or offsetting risk. That’s something an investor needs to avoid at all times, but especially in retirement.

If a stock reduces or even suspends its dividend, do you believe it’s time to sell? Or are you willing to give the company some leeway and hold the stock? Do you have a specific example of a company you held despite a dividend cut? How did it work out? Let us know what you think.