Must-know: Dividends as a hedge against stock market bubbles

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Nov. 20 2020, Updated 5:14 p.m. ET

Stock market bubbles and crashes

A bubble occurs when investors put so much demand on a stock that they drive the price beyond any accurate or rational reflection of its actual worth. Worth should be determined by the performance of the underlying company. Major market indices like the S&P 500 (SPY), Dow Jones (DIA) and NASDAQ (QQQ) can be seen surging to record highs during a bubble.

On the other hand, a crash is a significant drop in the total value of a market. A crash is almost undoubtedly attributable to the popping of a bubble, which causes the majority of investors to flee the market at the same time. The market incurs massive losses as a result.

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When stock markets surge to record highs, you can often hear the warning bells signaling a possible bubble. The housing bubble of 2008 is a good example (read The Great Deleveraging that never happened: The U.S. debt problem). The stock market, reaching record highs because of rising house prices, came crashing down in 2009—just after the Case-Shiller home price index reported the largest price drop in its history on December 30, 2008.


Why invest in dividend ETFs?

There are many choices of exchange-traded fund (or ETF) categories available to an investor. When markets are uncertain, however, dividend ETFs are best suited to conservative long-term investors. Dividend ETFs gain popularity when the markets are jittery, or when there’s a lot of uncertainty regarding the direction of the market or inflationary pressures, or when the market seems to be heading towards a stock market bubble (read A simple framework for deciding if you should stay in stocks).

Even if the markets pull back, you’re still paid dividends while you wait for a recovery. This is why investors tend to prefer dividends—they stabilize your portfolio, minimize risk, hedge against inflation, or create a comparatively stable revenue stream. Examples of dividend ETFs include the iShares Select Dividend (DVY) and the Vanguard High Dividend Yield ETF (VYM).

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