Dividend Trap

A dividend trap (or yield trap) is a stock whose dividend yield looks very attractive, but that high yield hides a deteriorating business, an unsustainable payout, or both. The usual outcome: a dividend cut followed by a further price drop — exactly the opposite of what the income investor was looking for.

It is one of the most expensive mistakes for beginner dividend investors, because the bait — 8%, 10% a year — appeals directly to the reason they invest.

How a trap is made

Dividend yield is calculated by dividing the dividend by the price. That means yield rises when the price falls. A stock trading at 100 with a dividend of 4 (4% yield) that collapses to 50 suddenly shows 8% on every screener — without the company raising its payment by a cent, and usually with fundamental reasons behind the fall.

The high yield is not the cause of the problem: it is the symptom. The market is pricing in that the dividend will not be maintained.

Warning signs

Before buying a striking yield, run through this list:

• Payout ratio above 80-100%: the company distributes almost all (or more) of what it earns.
• over several years.