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Investors enter the stock market for a variety of reasons. Some want to get rich quick, some are trying to build long term wealth and some are looking for income. It is this third group - those engaged in dividend investing - that this article is aimed at. Members of this group include retirees looking for a stable income and other investors looking for a passive income stream to supplement and eventually surpass and replace their primary income stream. But what are the traps in choosing stocks for their high dividend yield?

The first thing to check is whether the current dividend yield is sustainable. A simple way to check this is to look at the dividend payout ratio for any given prospective stock market investment. The dividend payout ratio is the percentage of profits which a company has distributed to holders of its stock. A payout ratio of greater than 100% could spell trouble. This means the company is paying out more to stock holders than it is making in profits. Obviously this isn’t sustainable over the long term. The most likely eventuality here is that the amount payed out to stock holders will drop in future years.

The second thing to check is the dividend history. Does the company have a consistent history of paying dividends? In the most recent period (upon which the published dividend yield is normally based) was the amount payed significantly higher than in previous years? If it is, can it be justified by a permanent increase in the level of profits? If not, in all likelihood, the payout will return to levels of previous years at some time in the near future.

The last thing to check is a little more difficult to pinpoint. A high dividend yield normally indicates that the stock price of a company is relatively cheap. This would normally be the result of negative market sentiment. Perhaps there’s been a profit warning. Or industry the business operates in might be in decline. Whatever the reason, you need to make it your mission to find out why the stock is cheap. Being armed with this information enables you to make a much more informed decision.

Once an investor is satisfied that the dividend yield is sustainable, the dividend history is strong and that there are no long term problems with the company, only then should they consider committing capital to such an investment. As with any investment in the stock market, dividend investing requires thorough research. Only then can an investor expect a good result.

Looking for more tips on dividend investing? Visit the Stock Market Investing For Beginners blog for more tips and information on dividends and other investing topics.

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