Investing for income: the power of dividends

When it comes to investing, stock dividends are a key consideration. Whether you reinvest them or use them for a regular income from your portfolio, it’s important to know how to maximise your dividend returns.

The value of investments can fall as well as rise, and you may get back less than you invested. Past performance is no guarantee of future results
Investing for income

Companies pay dividends to return a slice of their earnings to their shareholders. Essentially it is a way of ‘sharing the wealth’ generated by the business regardless of how its share price is doing. It is usually set as a ‘dividend per share’, so how much you get is proportional to the number of shares you own. Dividends can take the form of cash or stock, and may be paid quarterly or annually.

Sometimes companies may also pay special dividends. These are one—off payouts made when a company has excess cash on its balance sheet and wants to return some of it to investors. You’ll also often hear the term ‘progressive dividend’ policy, whereby dividends are generally increased on an annual basis as long as key rules are met.

In the UK stock market, a large proportion of total dividend payouts are concentrated among just a handful of FTSE 100—listed businesses; including oil giants BP and Royal Dutch Shell, pharmaceuticals company AstraZeneca, mobile giant Vodafone and bank HSBC. According to AJ Bell, just 10 stocks account for 59% of forecast FTSE 100 dividend payments for 2017.

Double whammy

Dividend stocks are popular with those who are investing for income because they give you a potential double whammy — you can benefit from the regular dividend payments, as well as any rise in the share price (although you should always remember that share prices can fall as well as rise). Many retirees invest this way because they rely on regular income payments to support their finances in retirement. But it’s not just about holding stocks or equity income funds, because bond and property investments are also popular strategies to generate income, and a balanced portfolio will combine these different approaches.

If you are not in retirement and you don’t need the regular income you can get from dividend payments, you shouldn’t let your dividends sit idly in a cash account. You can really ramp up your savings pot if you reinvest them instead by buying more shares in the issuing company. The power of compounding means your dividends can generate their own returns, and these are then reinvested to generate their own returns.

For example, if you had invested £10,000 in the UK market 20 years ago, the extra return you would have gained from reinvesting your dividends over that time would swell your savings pot by £12,384, according to JPMorgan Asset Management.

This process is the reason why dividends are sometimes said to account for the majority of stock market returns over the long term.

Where to start

If you’re ready to start investing for income, one option is to buy shares in well—known dividend payers such as oil, mining or pharmaceutical companies. Buying solid FTSE 100 names may sound like a safe strategy, but holding individual stocks brings greater risks than spreading your money across a diversified investment portfolio. If you want to hold shares, you need to do your homework. Remember that even big companies can struggle, and may not be able to maintain their dividend payouts if they fall on hard times. If you are set on holding direct shares, ideally you would look for those companies which have a track record in growing their payouts year after year, showing that they are sustainable, the business is consistently cash—generative, and it will be able to cover future dividends with earnings growth.

You could let an expert pick your stocks for you. There are some very respectable income funds on the market which have long and successful performance track records. You can choose equity, bond or property income funds, or select by region or company size. There are even monthly income funds if you want your investments to give you a regular monthly salary, or enhanced income funds which aim to deliver higher yields, often by using derivatives to maximise income.

Investment trusts can also be a useful option as their structure allows them to hold back cash reserves so they can continue to pay regular and growing dividends even when times are tough. For example, three listed investment trusts — City of London Trust, Bankers Investment Trust and Alliance Trust — have all managed to increase their dividends every year for the last 50 years, an impressive track record. You can buy these stocks just as you would any other.

Exchange traded funds (ETFs) are a popular low—cost way to generate income. For example, there are passive funds offering exposure to everything from US mid—cap dividend paying stocks, to emerging market names, to the highest dividend payers globally. ETFs have the advantages that they will often be easy to trade and can be cheaper than active funds. But bear in mind if you are buying a passive fund that tracks the FTSE 100 that concentration in those key dividend payers means you might end up over—exposed to a small number of stocks or sectors.

Use our ETF screener to research the right ETFs for you.

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