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Sin #3: Receiving a Return of Capital

This is one of those areas that should be treated like poison. When a big, fat, juicy dividend yield is composed in whole or in part by what is termed a "return of capital," you want to steer clear.

When a mutual fund or entity pays out a scheduled dividend payment that hasn't been earned by profits or interest income, you can bet that a portion of that dividend will be in the form of a return of capital, which simply means you as an investor are receiving some of your money back as part of the dividend.

Two negative things happen here:

1. First, by getting some of your principle back, it lowers your cost basis from a tax standpoint.
2. Second, if a dividend is being supported by a return of capital, then you know the underlying entity is in trouble.

Funds, partnerships, trusts and other hybrid structures know that cutting a dividend payout is like a death blow to a security that was purchased for its yield. And as a result, managers of those assets are loath to cut dividends and will use return of capital to maintain payout levels until things get better.

Needless to say, that last line is all about wishful thinking on the part of the manager but should be a waving red flag to the shareholder. Assuming things don't improve quickly, that asset will only depreciate with each effort to hold a dividend payout that is not supported by real fundamentals. Not a fun scenario.

NEXT: Sin #4: Buying Into Managed Distributions