Apart from the risk of inadequate diversification and from the fact that it may in practice be a closet form of stock picking, dividend investing entails other risks that we label under the moniker irrational factors. What are they?

As we discussed in our previous commentary in this series Six advantages of dividend investing: a critical assessment , according to financial experts there is an element of  irrationality associated with dividends. Investors should not logically pay more for shares of a company which pays dividends compared to shares of a similar company that does not. But many seem willing to do so:
 

Q: Why do some companies pay a dividend of $0.01? Why not just pay zero? There must be some important reason to remain a dividend-paying company. Does anyone know what that is?
A: Because the market loves when companies can pay dividends, even if it's just a small amount. That says the company is stable, making money, and has enough cash flow that they can pay the owners a little something. Source: from a forum on investing on  GotApex  (or as PDF doc.1528 ).

The danger here is that these feelings of irrationality may change over time for no apparent reason, thereby changing the demand for dividend paying stocks as a class. Asness notes that the relationship between the yields on shares versus bonds is unpredictable:

 the previously puzzling fact that stocks "out yielded" bonds for the first half of the 20th century, but have "under yielded" bonds for the last 40 years. Source: Asness (or as PDF doc.1529), in the abstract and at p.25

At the level of the individual company, a change in its dividend policy can suddenly make its stock more (or less) attractive for these irrational investors:

 One of the possible explanations about why dividends persist in spite of economists saying they shouldn’t is their signaling effect. So, a change in dividend policy may often indicate a change in the company’s fortunes. A cut in dividends will often signal reduced earnings – although it sometimes indicates that there are better earnings enhancing opportunities around. Similarly an unexpectedly raised dividend will often see a share price surge – even though this often indicates that the management have run out of ideas about how to deploy their spare cash, which isn’t exactly a positive sign. Source The Psi-Fi blog (or as PDF   doc.1530).

Supply and demand for dividend-paying stocks can also change due to taxation changes either at the corporate or shareholder level. When such changes occur, it may result in companies choosing  to reduce their dividends and to retain more funds for future growth, or to distribute their profits by buying back shares instead of paying dividends; see SmartMoney (or as PDF doc .1531) ; the Psy-Fi Blog (or as PDF doc.1532) ; Budukh Jacob, Roni Michaely et al (or as PDF doc.1533 ), and Arnott , p.11 doc.1466. Tax changes affect all issuers and shareholders, but their impact should logically hbe greater on dividend-paying stocks.

Finally, the preferences of irrational investors may affect the behavior of senior management of listed companies. Management may feel obliged to maintain at all costs a high dividend, even if the circumstances argue for the contrary;  see Hulbert (or as PDF doc.1534 ). 

This risk is called the dividend trap:

dividend trap risk- The decline in dividend cuts—a sign that payouts are better aligned with firms’ longer term financial capacity—has also reduced the risk from one of the potential perils of dividend investing. This is the so-called “dividend trap”—companies that offer a generous yield today, but may not be able to pay such high dividends or indeed any dividends in the future. Source : Shenfield et Buchanan, p.5 ( or as PDF doc.1512 ).

Some investors try to minimize this risk by avoiding very-high yielding stocks, but how high is too high? See StockInvesting Strategies (or as PDF doc.1510).  

All these risk factors can make dividend investing (a policy that attributes more value to securities that pay a dividend) in a company more or less attractive from time to time, even while the inherent profitability of the company has not changed. By investing in the market generally one minimizes the impact of such risks on our portfolio.

Conclusion

We hope that this commentary permits you to see some of the risks and disadvantages of dividend investing. In the last commentary in this series, we look at how (direct share purchases, investing in funds, reinvestment plans etc.) to dividend invest for those who wish to do so.