The stock market is an uncertain place, and for many investors the constant ups and downs can be a source of stress and anxiety. Yet there may be a solution: investing with dividends.
What are dividends and how do they work?
Dividends are the distribution of profits a company makes to its shareholders. If you own shares in a company that declares a dividend, you receive a slice of that money, and they can play a crucial role in long-term stock market returns.
While stock prices can fluctuate, sometimes wildly, in the short term, dividends provide a steadier return that can help to offset these movements. Although they are often overlooked, the reinvestment of dividends is a powerful force, compounding returns to produce substantial growth over time. Even if a share or the stock market doesn’t appreciate much, or even falls, the effect can mean your money still grows.
Are dividend stocks less volatile?
Occasionally, I’m asked: ‘are dividend stocks less volatile than other investments?’ My answer is, not necessarily. But a steady return from dividends can help generate long-term returns and bolster portfolios in periods of market stress. Higher dividend shares often have a valuation ‘safety net’ of the income stream they provide, so they can be less risky. This is because dividend payers are typically more established and more likely to generate consistent profits. Knowing that dividends are likely to continue rolling in can be reassuring for investors, especially in times of market uncertainty.
Remaining invested at all times 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. Holding stocks for long periods takes advantage of the long-term compounding of income, as well as the growth potential.
As well as being important for investors who are looking to build long-term wealth over time, dividend stocks can help to provide a stable source of income that can be used to fund income needs in retirement or other financial goals.
Risks of dividend investing
Investing in the stock market always comes with the risk of your investing falling in value, and when targeting dividend-paying shares investors need to be aware of potential ‘value traps’. Sometimes a dividend yield looks high, but it isn’t always sustainable. In fact, a very high yield could be a sign of distress. In these cases, if the dividend is cut or cancelled then the shares could fall in value, possibly substantially.
This is why investors should not solely focus on the highest dividend paying stocks or funds. Securing a lower, growing income tends to be more important in the long run than achieving the highest starting yield.
Looking at the current economic environment, dividends in certain sectors could come under pressure from rising costs or a weaker consumer. Every company and sector has its vulnerabilities, so it’s a good idea to have a broad range in your portfolio.
Company earnings, and therefore dividends, fall as well as rise, but over time as economies and industries expand there should be an upward trend in dividends, hopefully providing a reasonable hedge against inflation when you zoom out to the long term.
How to invest in dividend stocks
Investors can build their own portfolios of dividend-paying stocks, but funds offer a convenient way to achieve diversification across dozens of companies’ shares in one go.
Those with strategies targeting dividend-paying stocks tend to be found in either the Global Equity Income sector for international shares or the UK Equity Income sector for UK shares. Other, more geographically specialist, dividend-based funds can be found in their respective broad geographic sectors such as Europe ex-UK and Asia ex-Japan.
What is dividend reinvestment?
For income seekers receiving a growing stream of dividends can be very useful, but they can be a great source of return for any investor. Reinvesting dividends helps grow an investment pot through buying more shares or units to benefit from future growth.
When investing in funds, if income isn’t required, an investor can elect to buy accumulation units in a fund, rather than income units which pay the income out. Accumulation units in equity income funds reinvest dividends for you to turn income into growth and allow you to automatically compound dividend returns, and they can help form a more stable core to a portfolio compared to more growth-oriented or specialist funds.
With equity income funds typically offering yields in the region of 4-5% currently, and with the potential for the income to grow and compound over time, they could be an appealing option for investors, though remember all yields are variable and not guaranteed.
By Rob Morgan, Chief Investment Analyst at Charles Stanley
