Rob Morgan, Chief Investment Analyst at Charles Stanley discusses how to utilise dividends for personal finances.
The stock market is an uncertain place, and for many investors the ups and downs can be a source of stress and anxiety. Yet while share values fluctuate, dividends paid by profitable companies tend to be far more stable. That means investors who stay the course and ignore the day-to-day noise can receive an income stream that grows over time.
This is especially valuable for those looking to produce a sustainable retirement income resilient to the ravages of inflation.
John D. Rockefeller, the American business magnate and philanthropist once said, “The only thing that gives me pleasure is to see my dividends coming in.” It’s true there is something reassuring about dividends. As well as providing a healthy cash flow to investors, their payment signifies the health and confidence of a business.
Remaining invested can help harness the best returns from dividend paying stocks. Investors still get ‘paid’ during more difficult market periods when capital gains are harder to achieve. As well as being important for investors who are looking to build long-term wealth through reinvesting them, dividends can help fund income needs in retirement or for other financial goals.
What are recent UK dividend trends telling us?
Far from being a backwater of global investing the UK boasts an array of dividend champions that makes it an unexpected powerhouse for consistent income and decent if unspectacular overall returns.
A small dip in payouts this year belies underlying strength masked by a stronger pound diluting the value of overseas earnings for many larger, international companies. However, in the long run currency movements tend to fade in importance compared with the compounding effects of company earnings.
Not only is the UK market one of the highest yielding in the world but UK businesses are executing a high level of buybacks too, a pair of powerful engines to long term returns hiding in plain sight. Buy backs involve using earnings to reduce the share count and this process can magnify shareholder returns, complementing income generated through dividends and potentially increasing future payouts.
The UK stock market is often stereotyped as home to unexciting, traditional businesses overshadowed by the star tech companies in the US. But with these tailwinds and valuations at undemanding levels, investors armed with a disciplined strategy have a fine hunting ground to achieve growth in both income and capital.
How to invest to harness growing dividends
Investors can build their own portfolios of dividend-paying stocks, but ‘equity income’ funds offer a convenient way to achieve diversification across dozens of companies’ shares in one go. They represent diverse portfolios of shares – typically 50 to 100 – chosen by a fund manager. Usually they concentrate on finding large, international companies with the prospect of high and growing dividend pay outs.
For UK stocks these tend to be found in the UK Equity Income sector. If income isn’t required, an investor can elect to buy accumulation units in a fund, rather than income units which pay income out. Accumulation units reinvest dividends for you to turn income into growth and allow you to automatically compound dividend returns. They can also help form a more stable core to a portfolio compared to more growth-oriented or specialist funds.
For those relying on a steady stream of income it is also worth noting investment trusts are often well suited to dealing with periods of dividend cuts. They can retain some of their earnings in reserve whereas open ended funds must distribute everything they receive. When dividends come under pressure, the ability to dip into reserves can help smooth out any volatility of income.