What are dividends and how can they impact your portfolio’s performance? What is “income investing” and can dividends be used in this way to fund your lifestyle? In this article, our team at Hanson Financial Services (financial advice in Liverpool) offer some answers to these key questions. We hope you find this content useful and invite you to get in touch if you’d like to discuss your financial plan with us.
What are dividends?
When you hold shares in a business (e.g. via your investment account or ISA), some of these may mention a dividend. Simply put, this refers to a payment that the company makes to you – and other investors – once every quarter, six months or other frequency. It is a way of saying “thank you” to shareholders by distributing some of the company profits. The amount you get depends on how many shares you own and the “dividend yield”.
For instance, suppose a company pays out £0.50 every quarter; so, £2 per year (4 quarters x 0.50). If the stock price is valued at £100 per share, then the dividend yield would be 2% (i.e. £2 divided by £100, leading to 0.02 x 100). Naturally, a higher yield can make a company more attractive to potential investors. Lowering it, moreover, can annoy current investors who wanted the dividend and lead to people leaving the stock (often causing the price to fall).
Why dividends matter
Suppose you bought 100 stocks with each one paying a dividend. Suppose, also, that you never put another pound into your portfolio. Instead, you hope the value of your shares will grow. In the meantime, your investment account continues to receive cash injections from your dividends – allowing you to either withdraw them or invest in other shares. Dividends, as such, can make an investor’s “real returns” higher. If, for instance, a company increases its share price by 10% but also pays out a 4% dividend, then the total return (if the investor sold the stock after getting the payment) would be 14%.
The payment of dividends from your stocks, moreover, provides an encouraging sign as to their financial health. Usually, companies pay dividends out of their profits (unless they borrow money to pay them). Paying a regular dividend, therefore, sends a message to shareholders that things are going well and the company is in good health. Suspending or cutting the dividend – as many companies did during the height of the COVID-19 pandemic in 2020 – however, can suggest that the business is in financial trouble and cannot afford the payout.
The drawbacks of dividends
At this point, the reader could be forgiven for thinking that dividend-paying stocks must be better than those with a low (or non-existent) dividend. However, this is not strictly the case. It depends on the company – and also your investment strategy.
First of all, it is important to see why companies pay a dividend. Often, they do this because the majority of their customer growth potential is achieved. This makes it harder to add shareholder value by increasing sales and revenue. Rather, this can be offered by distributing dividends. As such, investors should ask why a company is paying dividends in the first place. Is it because they no longer see much more room to grow their market share?
For some investors, this may suit their strategy. For instance, an “income investor” is not so interested in capital appreciation (seeing the value of their shareholdings go up) but rather in receiving a regular dividend from their stocks – which they can then withdraw and use to fund their lifestyle. However, other investors will be more interested in capital appreciation so the overall value of their portfolio increases over time. Companies which put their profits mostly back into growing their business – rather than distributing to shareholders – are more likely to grow in this way over time.
Secondly, investors should be wary of assuming that a company is in good health just because it is paying a dividend. After all, it is possible for a business to take out debt to pay dividends – rather than from free cash flow. Here, investors can mitigate their risks of investing in stocks with poor balance sheets by seeking financial advice. An experienced professional can help guide you towards companies and funds with strong fundamentals. This helps to limit your risk of putting money into businesses that may be at risk of default. An adviser can also identify ways to reduce your “real returns” by finding cheaper dividend funds that do not compromise on quality.
Conclusion & invitation
Dividend-paying stocks and funds can be a great addition to an investor’s overall portfolio – yet need to be considered carefully in light of your investment horizon, goals and risk appetite.
Are you interested in talking to a financial adviser about your financial planning needs or portfolio? We’d love to assist you here at Hanson Financial Services.
Please contact us to arrange a consultation with our team – free and without obligation – to gain more clarity and peace of mind over your financial plan.
This content is for information and educational purposes only. It should not be taken as financial advice or investment advice. To receive tailored, regulated financial advice regarding your affairs please consult us here at Hanson Financial Services (financial advice in Liverpool).