Post-Madoff, Beware Benign Dangers

Every once in a while there is a sensationalistic story like the Madoff scandal to remind us, as if we needed it, not to put all our eggs in one basket.

Losing every nickel is the most dramatic outcome, though there are many more benign dangers. The likely consequence in these instances is subpar performance over a lengthy period, with the occasional blowup that can be foreseen.

I have been reading in articles, blogs and blog comments about a portfolio concept that seems to be universally adored but has pitfalls. Not knowing about the pitfalls can be worse than the pitfalls themselves.

The strategy I'm referring to is dividend investing. You might have noticed that many stocks now have very high dividend yields, so you should load up on the high yielders, collect the dividends and forget about the stock price -- just make sure you don't spend more than the dividends paid out (if you are in retirement). What could be better, right?

(Photo gallery: Reported losers in Madoff scandal)

There are drawbacks in placing too much emphasis on dividends. First is the top-down issue of being overexposed to one part of the market at the exclusion of others. Typically, big dividends are found in larger companies from certain industries that have a bias toward value. At times, smaller, non-dividend-paying growth companies lead markets.

A portfolio stocked with great companies boasting huge dividends, such as Altria (MO Quote) and Johnson & Johnson (JNJ Quote), both of which I own for clients, is not a diversified portfolio. Big-cap dividend payers don't always lead the market. Usually they don't. Owning too many stocks with the same characteristics does not make for good diversification and can actually make the portfolio more volatile.