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Dividend Investing: How to Recognize Risk Factors You Can't Control

You can’t always control what happens around you, and this is true of investing in the stock market. Inflation can soar, the Federal Reserve can raise or lower interest rates, bubbles can burst, and entire economies can crumble. However, by becoming more aware of these risks, you can develop strategies for dealing with them effectively.

Beating inflation

Inflation is a silent killer, eating away at your savings unless you put that money to work by investing it in something that earns a higher rate of return than the rate of inflation. And it’s worse than most people realize.

When you hear that inflation is at 4 percent, that doesn’t sound like much, but when you look at what a 4-percent inflation rate can do to your money over the course of 10 or 30 or 40 years.

Inflation’s Corrosive Effect on Purchasing Power
Inflation Rate 10 Years 15 Years 25 Years 40 Years
2% –18% –26% –39% –55%
4% –32% –44% –62% –81%
6% –44% –58% –77% –90%
8% –54% –68% –85% –95%
10% –61% –76% –91% –98%

Adjusting to interest rate hikes

When the Federal Reserve hikes interest rates, it hurts companies in a variety of ways, which can have a significant effect on dividends:

  • Interest rate hikes increase costs and slash the bottom line. With a higher interest rate, a company that carries a high debt load must pay more the next time it borrows funds.

  • Rising rates hurt business-to-business sales. When companies are spending more to service their debt, they have less money to purchase goods and services from suppliers.

  • Stocks become less attractive. When interest rates rise, safer investments earn a higher rate of return.

Investing in dividend stocks provides some protection against interest rate hikes. Even if the share price drops, companies often continue paying dividends, which offset the drop in price.

Monitoring market risk

Market crashes are a fact of life. Between 2000 and 2009, the U.S. stock market experienced two of the biggest crashes since the Great Depression. In addition, the market has fallen 10, 20, or even 30 percent many more times over the years. The main way to mitigate this risk is the same as for financial risk: research. Invest in good, profitable, stable companies because they tend to weather the storm better than most. And if you continue to invest during these stormy times, you can often find real bargains on your favorite shares.

Riding out a slumping economy

Like the stock market, the economy has its ups and downs. In fact, the stock market typically reflects current economic conditions. And, generally speaking, what’s bad for the economy is bad for the stock market.

As a dividend investor, you can’t control the economy or prevent an economic meltdown, but you can mitigate your losses and often gain ground in a slumping economy. Remember that a drop in share prices just may signal a perfect buying opportunity.

Reacting to changes in the tax code

The federal government often tries to influence consumer behavior and business practices through tax code. For example, when the government wants people to buy homes, it offers tax credits and other incentives to make homeownership more affordable. To stimulate economic growth, the government slashed the capital gains tax in 1981, which some analysts credit for triggering the bull markets of the 1980s.

Adjusting to shifts in government policy and actions

Although the stock market is filled with uncertainty, it does have a certain amount of predictability. When the government intervenes, however, predictability is tossed out the window. Yes, the United States does have a free market economy, but the government often steps in to influence it. And when the government steps in, the effects tend to ripple through the markets.

You may not be able to control or even predict changes in government policy, but it’s a good idea to keep up on the news and try to understand how specific policies or even talk of policy changes may affect your share prices and investment strategy. In addition, a slow, steady approach to investing can help reduce the effects of policy changes on your portfolio.

Remaining aware of credit risk

Keep in mind that banks aren’t risk-free either. They may seem safe, at least until credit risk (the risk of a loss caused by failure to pay) rears its head. A bank can fail to have enough cash to meet capital requirements, essentially owing more than it owns. This situation can cause a bank to collapse, and as the crash of 2008 demonstrated, collapsing banks aren’t just a historical phenomenon.

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