The Dogs of the Dow strategy focuses on dividends, which we think is a good idea. But beyond that, high dividend yields can be a warning sign, not a harbinger of rising stock prices

The Dogs of the Dow strategy involves buying the highest-yielding stocks in the Dow Jones Industrial Average (DJIA). It’s based on the idea that a high dividend yield is an indicator of an undervalued stock.

To apply this approach, at the end of each year, you pick the 10 stocks with the highest dividend yields from the 30 stocks that make up the Dow index. You then invest an equal dollar amount in each of these 10 stocks and hold them for one year. You repeat the selection process and re-jig the portfolio at each subsequent year-end. In theory, these stocks should outperform the market on average, measured by DJIA or the S&P 500.

In another variation, you pick the 10 highest dividend-yielding stocks, then select the five with the lowest stock price. Invest an equal dollar amount in each of those, hold them for a year, and repeat. This variation is known as the Small Dogs of the Dow, or simply The Dow 5.

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The ALPS Sector Dividend Dogs ETF (symbol SDOG on New York) follows its own version of the Dogs-of-the-Dow strategy. It picks five stocks with the highest dividend yields from each of the 10 sectors of the S&P 500 index. These sectors are consumer discretionary, consumer staples, energy, financials, health care, industrials, information technology, materials, telecommunication services, and utilities.

Each holding begins with roughly the same dollar value, so every company starts out with a similar influence on the ETF’s total return. The end result is a portfolio of 50 large-cap stocks.

Of course, any kind of rule can give you good results in some particular time period. But just like it can give you really good results in one time period, it also can go equally wrong in another time period. There’s an old expression, or saying, that high yield may be a danger sign rather than a bargain. And that’s the constant risk you’re faced with, with the kind of stock picking rule that puts too much weight on a single factor, namely, dividend yields.

So, I prefer to build a portfolio of diversified, well-established companies. You’ll have a variety of yields in there. Some things will yield 1%, some will yield 5%. But I think you’re better off doing that because the results may not be better in a good year, but I think they will tend to be better in a bad year.

The Dogs of the Dow strategy worked in the 1990s

One best-selling book of the early 1990s advised investors to buy the Dogs of the Dow—the lowest-priced, highest-yielding Dow stocks. Followers of the approach made money. Of course, anybody who bought stocks in the early 1990s made money.

The Dogs of the Dow strategy worked well in the 1990s because interest rates were going down. This tended to raise all stock prices. But high-yielding stocks were affected more than most, because they attracted bond investors who were switching into stocks.

That’s how things work for most formulaic approaches. Sometimes they seem to add value, because they happen to lead to investment in stocks that were likely to go up for some reason other than the formula’s actual focus.

Today, with rates as low as they are—as low as they’ve ever been—they can’t go much lower. That means high-yielding Dow stocks can’t count on falling interest rates to further push up their appeal and share prices.

Blue-chip dividend-paying stocks are still best for your portfolio—just not with a Dogs of the Dow approach

It’s realistic to assume dividends from blue chip companies will continue to contribute around a third of your total return. In addition:

Dividends can grow. Stock prices rise and fall. Interest on bonds holds steady at best. But dividend paying stocks like to ratchet their dividends upward—hold them steady in a bad year, raise them in a good one. That gives you a hedge against inflation.

Dividends are a sign of investment quality. Some good companies reinvest profit instead of paying dividends. But fraudulent and failing companies are hardly ever dividend paying stocks. So if you only buy stocks that pay dividends, you’ll automatically stay out of almost all the market’s worst stocks.

For a true measure of stability, focus on those companies that have maintained or raised their dividends during the recent recession and stock-market downturn. That’s because these firms leave themselves enough room to handle periods of earnings volatility. By continually rewarding investors, and retaining enough cash to finance their businesses, they provide an attractive mix of safety, income and growth.

To find the best stocks to invest in, use our three-part Successful Investor philosophy:

1. Hold mostly high-quality, dividend-paying stocks.
2. Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.
3. Downplay or stay out of stocks in the broker/media limelight.

What is your opinion on seeking out stocks with high yields? Do you find that to be a risky investment approach or has it worked for you?