As a dividend-focused investor I’m always on the lookout for high yield shares, whether that yield is high relative to the market average or high relative to the company’s peers.
However, as most yield-seeking investors soon discover, high yield stocks do not always deliver the yield you were hoping for. That’s because dividends can be cut or even completely suspended, and the higher the historic or forecast yield the more likely that is to happen.
This is the dreaded yield trap, where investors are lured in by an attractive yield and then stung with a capital loss when the dividend is cut.
In order to avoid this fate where possible, I’ve built up a series of questions which every potential investment must answer before I’ll invest so much as a penny. These questions are designed to help me avoid companies that are exposed to significant risks, where those risks arise from factors such as large acquisitions, excessive expansion or changing patterns of market demand.
Of course, these questions are not foolproof, but I’ve found them extremely useful in recent years and in the latest issue of Master Investor magazine I’ve covered the first six yield trap questions in some detail:
How to avoid yield traps – Part 1