You will be able to explain how a falling price creates a high yield and how buyers get caught.
Somewhere in your feed is a post from someone who found a stock yielding eleven percent, bought a decent amount and is already spending the dividends in their head. If they post again a few months later, it reads differently: the dividend was cut, the price fell further, and now they cannot decide whether to sell at a loss or wait.
That second post is so common that the situation has a name. This lesson takes it apart step by step, with figures, so you can recognise it before you are in it.
A yield trap is a stock or REIT whose high yield reflects a falling price ahead of a dividend cut. The yield looks high because the market expects the payout to shrink and has already marked the price down. The buyer sees last year's dividend against today's lower price and reads it as a bargain. The market sees next year's smaller dividend coming.
Lesson 2.1, Dividend yield looks backward, explained the mechanism. The yield divides past dividends by a current price. When the price falls before the dividend does, the yield rises, and it rises most for exactly the stocks where trouble is closest.
Here is a made-up example. Follow the numbers, because the pattern repeats in real cases with different figures.
A stock trades at S$2.00 and pays S$0.16 a year in regular dividends, a yield of 8%, from a business that carries some debt and is under some pressure.
Over the next year, sales slow and the company's debt costs rise. Investors who follow it closely start selling. The price falls to S$1.40. The company has not yet changed its dividend, so the trailing yield, S$0.16 over S$1.40, is now about 11.4%. Screeners show it as roughly 11%. It appears near the top of every high-yield list.
This is where new buyers arrive, some of whom have never looked at the company before, and on the strength of 11% and a familiar name they buy at S$1.40.
Then the company reports its results and halves the dividend to S$0.08 a year. On a price of S$1.40, that is a yield of about 5.7%. The 11% the new buyers saw was never on offer. It was last year's payout on this year's price.
And the price often falls again after the cut. Some holders bought only for the income and now sell. Others take the cut as confirmation that things are worse than they hoped.
Take the investor who held from the start. They bought at S$2.00 and collected S$0.16 in dividends over the year while the price fell to S$1.40. Their total return, as in lesson 1.4, Track one dividend and its total return, is the price change plus dividends: minus S$0.60 plus S$0.16, so minus S$0.44, which is a loss of 22% on S$2.00. They collected every payout on schedule and still lost more than a fifth of their money.
Now the new buyer at S$1.40. They chased an 11% yield. They now hold a payout half the size, on a stock whose price may well keep falling. If the price drops further after the cut, the dividend they receive will not come close to covering it. In the activity you will work out exactly how much they lose under one set of made-up figures.
The trap is not that the stock fell. Prices fall all the time. The trap is that the high yield drew in buyers at the moment the risk was greatest, and told them the opposite of what the market was signalling.
Three things make the trap work.
The yield figure looks like a fact, because it is built from real payments. Buyers trust it more than a forecast, even though it is backward-looking.
The cut is announced in a day. The warning signs build up over months in the cash flow statement, the debt notes and the tone of management commentary, which most people never open, and lesson 3.2, Warning signs that a dividend is about to be cut, goes through them.
And a falling price feels like an opportunity. Buying more of something you like at a lower price is a sound instinct for a business whose prospects have not changed. It is a costly instinct for one whose prospects have.
Some stocks yield more because they grow slowly, or because their sector is out of favour, or because the whole market has fallen. Treat a high yield as a reason to look harder, and save the verdict for after you have looked. Lesson 3.4, Run the yield trap check on a high yielder, gives you the checklist to tell the cases apart.
Before the checklist, work through the numbers once more yourself, this time from the point of view of the buyer who arrived at S$1.40.
Using the made-up example, calculate the total return for a buyer at S$1.40 if the price falls to S$1.10 after the cut and one payout is received.
Junxiong-WFG Organisation is an authorised representative of AIA Financial Advisers Private Limited (Reg. No. 201715016G).