A strategy to beat dividend stocks

Dividend stocks that protect your portfolio from the worst losses are also quite likely to prevent you from earning the biggest profits

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For years, investors have looked to dividend stocks as a great all-purpose investment. Not only do dividend stocks provide you with the income many people need to cover living expenses, they also often provide some downside protection when markets start to decline.

But just because dividend stocks have favourable characteristics doesn't mean that they're always your best bet. In particular, when you expect the market to rebound sharply, sticking with dividend stocks — especially in defensively positioned industries — can lead to subpar returns.

Looking back at the "junk stock" phenomenon
In 2009, during the depths of the financial crisis, the stock market seemed to be in serious trouble. Many companies were on the verge of failure, as tight credit conditions made it nearly impossible for cash-poor businesses to get the financing they needed. As a result, investors gravitated toward companies in better financial shape, with cash reserves to survive however long the crisis might last. Many of those safer companies were dividend stocks, with business models that not only produced enough cash to finance ongoing operations but also left enough additional money to make dividend distributions to shareholders.

But when the stock market turned around and started to recover, these safer stocks weren't the big winners. Many analysts complained that the companies that rebounded the most strongly were those that arguably deserved it the least: so-called "junk stocks" that had extremely high risks of bankruptcy. Ford (NYSE: F), Freeport-McMoRan (NYSE: FCX), and Las Vegas Sands (NYSE: LVS) had all seen major disruptions to their businesses — with Ford suffering from weak demand, Las Vegas Sands teetering under huge amounts of hard-to-refinance debt, and Freeport dealing with commodity prices that plunged during the market meltdown. Yet they were among the top-returning stocks of 2009, leaving their safer counterparts in the dust.

Recent history
You can see the same phenomenon in the big run-up that stocks enjoyed between last October and the end of April. The S&P High Yield Dividend Index posted strong gains during that period, but it nevertheless underperformed the overall S&P 500, and it greatly underperformed more aggressive measures like the small-cap Russell 2000.

Specific stocks show this even more clearly. Johnson & Johnson (NYSE: JNJ) barely budged during the summer plunge last year that lopped off more than 20% from the S&P 500, but it has also stayed close to flat during the ensuing recovery, and its core businesses have remained relatively stable throughout the period. Procter & Gamble (NYSE: PG) was a bit more volatile as it had to deal with rising costs for raw materials, but it too has been steadier — and less lucrative — during the bounce.

Could it happen again?
Of course, it's far too early to start talking about whether the current correction will eventually get anywhere near as bad as the 2008-'09 bear market was. After all, the S&P 500 is still up for the year so far, and while analysts are as always divided about the most likely direction for the market to move in the near future, it's entirely possible that stocks have already seen their worst levels and will rise from here.

But regardless of when stocks bottom out, the thing you should remember is that if you want to maximise your gains in the next big bull market run, the same dividend stocks that protected your portfolio from the worst losses are also quite likely to prevent you from earning the biggest profits.

Consider your objective
To make the best investments, you have to know your objective. If you're ambitious and are willing to trade in and out of stocks to capture the best returns possible from any market environment, dividend stocks could hold back your results during major bull markets. But if you want to buy and hold stocks for the long haul rather than trading in and out of stocks, then the risk-reward profile of dividend stocks may be exactly what you're looking for.

If you're in the market for some high yielding ASX shares, look no further than our "Secure Your Future with 3 Rock-Solid Dividend Stocks" report. In this free report, we've put together our best ideas for investors who are looking for solid companies with high dividends and good growth potential. Click here now to find out the names of our three favourite income ideas. But hurry – the report is free for only a limited time.

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The Motley Fool's purpose is to help the world invest, better. Take Stock is The Motley Fool's free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead. Click here now to request your free subscription, whilst it's still available. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

A version of this article, written by Dan Caplinger, originally appeared on fool.com

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