Some think the idea of buying shares is to live off the dividend income and watch the value of the shares rise in the longer term to protect your capital against inflation. Whilst individual quarters or even years can see falls in share values, over time a portfolio of shares usually appreciates by more than price rises, whilst paying you a growing income from dividends.
Some people, and some funds, follow the logic of that and seek out shares that pay a bit more dividend than the average so they can spend a bit more from the higher income. Sometimes they do well, as the shares still go up in value by as much as the rest of the market, so you win from the extra dividends. Other times you lose, because the higher income shares fall behind the rise in the general market by more than the extra money you earn on them. We have just lived through a prolonged period when higher-dividend shares on average have been out of favour and they have lagged a lot.
Higher-dividend shares are a mixed bag of investments. Some shares have a high apparent income because the company is under financial pressure and is about to cut the dividend or stop it altogether. The price of such shares often falls in advance, as investors work out the company is in trouble. The way the dividend income – or yield – is calculated is normally based on the past years payments, not on the likely future ones. If you buy too many shares like that you lose out on both income and capital values. Then there are numerous shares in companies that have little or no growth in turnover and may be highly regulated. They have to pay a high dividend to reassure shareholders, but often cannot afford increases in the dividend. These shares too often lose out in a bull market when faster growing companies on lower dividends can increase their payouts quickly.
The best type of high-dividend company is one that has been down on its luck and has a low share price because of past poor performance, but it now appears it is about to perform better. If shareholders can look forward to profits and dividend growth after falls then you may benefit from both a rising payout and from a surging share price as more come to believe in the recovery. There are also good steady cash generating companies that can pay out a consistently high dividend with modest increases in payment.
Growth shares are at the other end of the spectrum. Some fast growing companies do not pay a dividend at all. They need the cash to invest in the business, so they do not pay an income. Some argue that a fast growing company, which can afford to pay a dividend, should reinvest the money in their business as they can earn a higher return than paying it out and letting the investors invest in less exciting opportunities. In the big bull market in technology companies exploiting digital technology in recent years few professional investors have worried about the low dividends or no dividends from the brightest and best companies experiencing huge growth. Investing in the Nasdaq US technology index of specialist companies has been particularly rewarding with high levels of capital growth.
Balancing the market
So, how can we reconcile many investors need for some income from their portfolio with the moods of the markets, which means sometimes the very shares that can give you a decent income will let you down on capital performance? One of the ways to think about your investments is to look at both the income the shares produce and the capital gains. If you consider this total return, you can then draw down a mixture of the dividend income and some capital gains to meet your spending needs each year. As long as the total value of the portfolio after you have taken money out is still higher than the previous year and has gone up enough to cover inflation, you can afford to spend some of the gains and all the income and still not be worse off. If, for example, your share portfolio paid you just 2% in dividends, but also recorded a 5% capital gain, you could afford to draw out 2% of capital as well as the 2% income if inflation was below 3%. You would have enough left in the fund to keep the same spending power as the fund had still gone up by the 3% to cover inflation after you have taken some money out.
There can also be tax advantages in getting some of the increase from capital gains rather than from income, depending on your respective rates of income tax and capital gains tax. It is often a good idea to look at the return net of any tax you will pay on the income and the gains.
Some charities which need to grow their endowments for the future – and which plan to be around for decades or centuries – use an approach they call sustainable income. They decide what return they can draw out of the fund taking into account how much income it is likely to earn and how much gain it is likely to make on average year by year. They even draw down in a year when the portfolio falls, taking the longer-term view of the likely returns. In winning years they allow the fund to build up by more. Charities, of course, usually are tax free on both gains and income which makes it easier for them. It is still a good concept to think about when deciding whether dividend income matters to you, and if so how much you should ask your investment manager to try and earn. If you ask for too much income there may be a cost in lower capital gains.
Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal. Past performance is not a reliable indicator of future results and that the price of shares and other investments, and the income derived from them, may fall as well as rise and the amount realised may be less than the original sum invested.