With combined dividends of the FTSE 100 share index yielding around 4.8%, you may be tempted to invest more of your cash in dividend paying stocks.
Why keep money in cash savings earning 0% interest when it could be earning 4.8% from dividend pay–outs?
Whilst dividends are a key component of a successful investment strategy they are not the be all and end all. No dividend is safe and in fact the higher the dividend pay-out can often mean the company is in more trouble than you realise.
How dividends work
When you invest and purchase shares in a company, you own a piece of that company. Therefore if the company makes a profit, a share of that profit is owned by you. Companies will pay you your share of the profit by way of a dividend.
Now not all companies will pay dividends. For a start, a company needs to be making a profit to pay a dividend. But also younger companies who are keen to keep expanding and grow will often re-invest profits back into the company rather than pay out to shareholders.
Remember there are two ways to make money from investing. From a share in the company’s profits (dividends) or through an increase in the value of the company overall (capital gain).
The larger more established companies who have already conquered their market quite often can’t expand at the same rapid pace so therefore pay more of the profits out as dividends.
I have come across many DIY investors who have built a collection of shares in large companies paying regular dividends. They like the fact they see a regular income coming into their bank account. Some investors in retirement will even rely on these dividends to provide their pension income.
This strategy can quite often lead to a disastrous outcome some way down the line.
At some point every business will go through some form of crisis that will impact their profits. Worse still, most businesses will lose market share and even lose their market at some point in their life. Think Blockbusters, Kodak etc.
We are currently going through one of the worst economic crisis the world has ever faced and the result? Global dividend yields have suffered their biggest quarterly fall since the financial crisis.
You might think some of the largest companies in the world are immune to these troubles but let’s look at some recent examples:
- UK banks such as Lloyds, RBS, Barclays and HSBC suspended dividends on advice from the Financial Conduct Authority to ensure they have enough cash to get through the global pandemic.
- Telecoms giant BT recently cancelled their dividend for the first time ever due to rising costs of upgrading the UK’s broadband network.
- In 2010 oil firm BP cancelled its dividend to help deal with the fallout from the Gulf of Mexico oil spill.
- In 2015 supermarket giant Tesco cancelled their dividend following the fallout of the accounting scandal and a few poor years of trading results.
So it’s clear that even the biggest companies will cut or stop their dividends at some point and if you are holding the stock that means a cut in your income. The share prices of all of the companies in the above examples also suffered sharp falls.
The right investment strategy for dividends
So how should you use dividends?
Well dividends can be a good way to value a company but you need to be careful.
For example a company with a higher dividend yield than its competitors may mean that company seems a better investment opportunity. But it could also mean that the company paying the higher dividend yield has suffered a fall in its share price therefore making the yield seem higher. The fall in share price would need to be investigated.
Quite often the higher the dividend yield (particularly when compared to similar companies in the same sector) means that the dividend is unsustainable and likely to be cut in the near future.
Dividends can be useful when a share price temporarily falls as it means you still get a return from the dividend and you could use the dividend to re-invest into purchasing more shares at a cheaper price.
So rather than rely on dividends as the sole driver for your investment return, it is better to mix dividends and capital growth.
This involves investing in a broader range of investment assets, geographical locations and sectors.
For a start, using investment funds like open ended investment companies (OEICs), unit trusts, Exchange Traded Funds (ETFs) and Investment Trusts will allow you to pool your money with others and invest in a much larger range of companies. Some new and fast growing companies and some larger dividend paying companies. You then benefit from the best of both worlds.
Also by using different assets like fixed interest bonds, property and commodities like gold, your portfolio risk can be reduced as different assets perform better in different economic environments.
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Stock market linked investments and any income from them, can fall as well as rise and is not guaranteed. Any figures quoted are for illustrative purposes and should not be taken as a forecast or guarantee. Past performance should not be seen as an indication of future returns and clients may get back less than they have invested.