How do you invest for a longer term return, and still get paid while you wait?! The answer is investing in dividend stocks – companies that regularly dole-out cash payments. It makes for really passive income, which is great if you’re retiring. That said, they can also provide juicy returns for investors with longer horizons who reinvest their dividends. Here, we guide you through dividend investing, and how to do it through easy fund investments.
What’s wrong with savings accounts?
Not a single saving account beats inflation right now. That’s right, none! This is unusual against history. Just one year ago, there were over 300 savings accounts that offered interest ahead of inflation, and the year before that, over 100. It means today, the value of your savings is actually going down over time (we have a quick video explaining inflation here). You need to learn how to invest to stop the value of your money crumbling away. One approach is by investing in dividend stocks. It involves some stock market risks, but dividend income funds spread these risks widely. Let’s start from the top.
What are dividends?
When you buy a stock, it may pay you – as a shareholder – a portion of its profits. This is known as a dividend.
What’s great about investing in dividend paying stocks is that they can kick out cash while the share price grows. So there’s two aspects to the returns you get when you invest in dividend stocks. The growth of the share price, and the dividend yield you receive each year. Yield just expresses how big the dividend is relative to the share price. If a stock is 100p to buy, and it pays out 5p per year, then it’s on a 5% yield. (See our animation on yield).
Which companies pay dividends?
Generally, it tends to be the ones that have been around for a bit of time, so are fairly mature. Paying dividends means they’ve got to the stage where they are generating some tasty profits. Perhaps they have more money than there are quality projects to re-invest in within the business. As such, they may not need to hoard sacks of cash on the balance sheet and can hand back some to the shareholders.
Some investors really like steady dividend paying stocks because it shows the company is confident in its future and its ability to continue generating profits, that the management team are well disciplined with the finances, and that it isn’t wasting money on silly projects that won’t add much value. Like a vanity painting of the Chairman for his office.
How are dividends paid?
The board of directors will get together and decide how big the next dividend will be, and if they are regular dividends, usually these are quarterly. But they could be paid monthly, semi-annually or annually. Sometimes they may pay a special dividend – a one-off if they suddenly have loads of cash they don’t need, for example after selling part of the business. One bit of jargon is the ex-dividend date. You need to buy shares before the ex-dividend date in order to receive its next dividend.
How do I start investing in dividend stocks?
Well, first thing to do is to select an investment platform / share dealing service and open an account. Here, we have a video explaining what we mean.
And you must use an ISA!! This is the same as any investing account but it comes protected from any form of tax. This is very important to do. Helpfully, we also have a video on ISAs here (and SIPPs, a tax protected account for pensions).
Once you have an account, you can start searching through the lists for different investment products, which include individual shares as well as loads of funds, some run by fund managers, and some not.
Do I just go out and pick some dividend paying stocks then?
We don’t actually think this is the best way to invest in dividend paying stocks. This is largely because investing in stocks takes lot of time and resources. Experienced fund managers we know can spend 2 or 3 weeks analysing a single stock. You have to really understand what the company does and how it does it, and rummage through all of its finances to find out if it’s solid and profitable, and can defend those profits to continue paying dividends.
One problem, for example, is that high yielding stocks are deceiving. Remember the yield represents the dividend as a function of the share price. So, the yield might be high because the share price has plummeted as the company isn’t doing so well, investors are selling the stock, and it could be about to cut that dividend. It’s why you really need to understand the business well.
Second, individual stocks are quite risky as you are very exposed to whatever happens to an individual company. It could go bankrupt or could simply need to cut its dividend for a while for one reason or another. You could build a portfolio of 8 or 10 stocks over time to diversify some of those risks. But a fund that invests in income paying stocks would probably have around 50 stocks, across a number of business sectors, so they are very well diversified.
We’re going to go through that next so stay tuned. Please like and subscribe to the channel if you’re enjoying the videos.
If you do want a crack at dividend stocks, one bit of info we like is below from AJ Bell, an investment platform. It takes a look at dividends in the FTSE-100 and gives you information on important data you might need and explains it quite well.
How do I go about investing in funds for dividend income then?
Funds are arranged in sectors – groups – according to what they are trying to achieve. For dividend income you are looking for sectors on your investment platform labelled as something like ‘equity income’. This is because shares are commonly called equities in the investment industry. And there will be a few different flavours and choices to make.
One big decision will be, where in the world do you want to be invested. You can get a US equity income fund, a UK equity income fund, a European one, a global one, and so on. This just puts fingers in different pies in case something drags a particular market down for a while. The UK market is actually very renowned for equity income because companies here are quite mature and they pay out a fair whack in dividends. But, over the last few years, the UK market was dragged lower by Brexit uncertainty in the economy. So, diversifying geographically is smart.
Second is whether you want a fund run by an investment professional known as fund manager, or to use a fund that just mimics buying a particular group of companies, for example simply copying the FTSE100 – the largest 100 companies in the UK. Let’s have a look at these two options.
Funds with a fund manager
A fund run by a fund manager comes with the advantage of an investment professional sifting through a market to find the best stocks to put into a fund to meet its objectives. But they come at a cost, you have to have to pay for their services.
There are two types of fund: funds and investment trusts. We have a great animation on the differences, link here. The potential of picking great performing stocks is the advantage of using a fund manager. But there are few downsides too. Funds that don’t have a fund manager are much cheaper and so will eat away at your returns far less. And then there is also the chance that the fund manager doesn’t pick very good stocks and the fund doesn’t perform very well.
Funds without a fund manager
Funds without a fund manager come with the advantage of being cheap. They simply mimic the index they are tracking, buying all the same stocks in the same proportions. They are called names like ETFs and index trackers and index funds. Now, if you’re looking for equity income, there are trackers and ETFs that are tilted towards companies that pay strong dividends – that have a good yield. Ed Bowsher recently wrote on this in our latest free magazine, check it out here.