For five years now, retirees have suffered from rock-bottom interest rates that have dramatically reduced the income they could earn from safe investments like bank CDs. Combined with below-average increases in monthly Social Security checks in recent years, the pressure of falling investment income has made it difficult for many retirees to make ends meet.
As a result, many retirees have shifted into dividend-paying stocks as an alternative to fixed-income investments. But in doing so, though, they've added substantial risk to their portfolios and left themselves open to questionable strategies that could produce massive losses if things go wrong.
Let's take a look at three of the biggest mistakes retirees must avoid in using dividend stocks to generate income.
Mistake 1: Indiscriminately Picking the Highest-Yielding Stocks
When you're hungry for income, there's nothing more appetizing than a high current yield. Even with bank account interest rates as low as they are, you can find several dividend-paying investments that offer yields above 10 percent. For retirees who got used to the 5 percent to 6 percent rates that used to be common on CDs, finding double-digit yields can seem well worth taking on some risk.
What many investors don't realize, though, is that just how great their danger is. For instance, mortgage REITs Annaly Capital (NLY) and American Capital Agency (AGNC) earn their high yields by using vast amounts of leverage to maximize income from much lower-yielding bond investments that they hold. As fears about rising interest rates have hit the market, both of these mortgage REITs have cut their dividends and seen their share prices decline. Moreover, rural telecom company Windstream (WIN) recently paid a 12 percent yield, but it produces far less in earnings than it pays out in dividends. That raises questions about whether the company will be able to sustain its payouts, especially as competitors in the industry have had to cut their own dividends in recent years.
Mistake 2: Overpaying for Stability.
At the other end of the spectrum, many retirees feel more comfortable buying blue-chip stocks that pay more modest -- but still attractive -- dividends. Companies like Procter & Gamble (PG) and Coca-Cola (KO) are household names that have been in existence for decades, and retirees in particular feel comfortable with their longevity and their yields in the 3 percent range.
%VIRTUAL-article-sponsoredlinks%But demand for dividend stocks has been so high that many of the most popular dividend stocks have seen their valuations get expensive. Both P&G and Coca-Cola have share prices that are more than 20 times what they earned over the past 12 months, a level that's fairly high compared to past valuations.
Before you just buy a familiar name, check the P/E ratio and other related data make sure you're not overpaying for the stock, or else you could be in for some ugly losses the next time the stock market stops feeling exuberant.
Mistake 3: Ignoring Companies' Lack of Growth Potential
One threat retirees understand is that rising rates can hurt the value of long-term bonds. But what they don't realize is that many dividend stocks are tied to the same forces that affect long-term bond values. In particular, those companies that don't have strong growth prospects tend to trade much like bonds, falling in value when rates rise.
To avoid that phenomenon, you need to look beyond dividends to identify stocks that also have future growth potential. Public Storage (PSA), for instance, pays a yield above 3 percent based on the income it generates from its self-storage units. But it has also seen earnings grow substantially as demand for space has grown. That combination gives dividend investors two ways to profit.
Be Smart About Dividend Stocks
Retirees can use dividend stocks to help them bridge their income gap and get the money they need for their everyday living expenses. But you have to avoid these big mistakes in order to protect yourself from the lifelong financial damage that can result from bad choices.
Ways Retirees are Making Money
3 Investing Mistakes Retirees Must Avoid At All Costs
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Starting a blog is a great way to share your passion with the world, while making some extra money. There are plenty of online resources to teach you how to start, run and monetize a blog on just about any topic that interests you.
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Upcycled furniture is all the rage today, but some people simply don't have the time to spray paint and decoupage old pieces to give them new life. Retirees could upgrade old pieces of furniture and sell them online or locally, or offer their services for custom furniture upgrades.
You can follow Motley Fool contributor Dan Caplingeron Twitter@DanCaplinger or on Google+. Hedoesn't own shares of the stocks mentioned in this article.The Motley Fool recommends Coca-Cola and Procter & Gamble. The Motley Fool owns shares of Coca-Cola.