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Beware! This Surprise Lurks in Wait for Dividend Investors

Dan Caplinger, The Motley Fool

The Dow Jones Industrials (DJINDICES: ^DJI) are headed toward another winning year. Yet conservative investors worry that after nearly nine years of strong bull market returns, a substantial correction in the stock market is long overdue. Dividend stocks have a reputation for offering protection against bear markets, giving investors the promise of reduced volatility as well as paying shareholders income along the way.

Yet just because dividend stocks can be smart long-term investments doesn't mean that they're able to withstand major market downturns unscathed. A look back at the results of the popular Dogs of the Dow strategy shows how even a largely successful method of investing won't necessarily save you from the next bear.

Desk with glasses, a calculator, $100 bills, and a notebook with word Dividends written in it.
Desk with glasses, a calculator, $100 bills, and a notebook with word Dividends written in it.

A quick primer on the Dogs of the Dow

For dividend investors who aren't familiar with the Dogs of the Dow, the strategy behind the popular investment strategy is easy to understand. It involves picking the 10 Dow stocks that have the highest dividend yields at the beginning of each year. You then purchase an equal amount of shares of all 10 stocks and hold them until the end of the year. At that point, you then reassess, looking at how price changes have affected yields among Dow stocks and coming up with an updated ranking by yield. For the next year, you replace any stocks that have fallen out of the top 10 with the stocks that have moved up over the year.

The Dogs of the Dow have done quite well during the recent bull market. It has outperformed the Dow at large in six years out of the most recent seven, with higher yields also giving investors who use the strategy more income.

Why the Dogs of the Dow aren't perfect

The problem is that the Dogs of the Dow haven't always been able to provide the protection from market downturns that many investors expect. Indeed, some years have produced worse losses using the Dogs of the Dow compared to simply investing in the index itself.

For instance, during 2008, the Dow Jones Industrials were down 37%. Yet the Dogs fell an even greater 42%. The primary culprit: bank stocks. Two major banking stocks were among the Dogs, as was industrial conglomerate General Electric, which at the time had huge amounts of exposure to the financial industry. Indeed, the Dogs narrowly escaped even worse losses, because Bank of America was admitted to the average in February and therefore missed out, even though its yield would normally have left it among the Dogs as well.

Things were only a bit better in 2001. The Dogs lost 8%, compared to a 7% drop for the Dow at large. Poor performance from banks, telecommunications, and photo giant Eastman Kodak contributed the most to underperformance.

The Dogs haven't always been a failure. In 2000, they posted a 3% rise, avoiding the Dow's 6% drop. The reason: tech stocks largely paid no dividends, and they were the biggest decliners in the Dow that year. 2002 had a similar profile, with the Dogs losing only 12% compared to a 17% drop in the Dow. Again, high-flying growth stocks generally underperformed the higher-yielding dividend payers that year, helping to salvage a better showing from the Dogs.

What investors need to prepare for

One thing that's been pretty unusual during this bull market is that dividend stocks have done as well or in some cases even better than the market at large. Typically, defensive names underperform in bull markets, leaving them with a greater margin of safety when corrections occur. The fact that traditionally defensive stocks have done so well points to the risk aversion that some investors feel about the market, and their higher valuations could give them further to fall in the next correction.

The Dogs of the Dow have been a reasonable long-term strategy for investors looking to squeeze more income from the components of the Dow Jones Industrials. However, their past performance during bear markets shows that dividend stocks aren't invulnerable to market challenges. Only by being aware of the risks and taking steps to protect yourself from them will you be able to make the best use of dividend stocks in your portfolio while avoiding possible traps along the way.

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Dan Caplinger has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.