Even with recent increases, interest rates are still very low. For anyone who keeps any material amount in bank accounts or fixed deposits, it’s been obvious for a while that the level of interest is nothing to write home about. With bank interest well below the current high rates of inflation, your cash is actually losing value every year.
But it’s not just bank accounts that are impacted by low interest rates. Most fixed interest investment income from bonds and gilts is also based on current interest rates. This means that the income (yield) you can earn from these at the moment is also generally very low. So with interest and income hard to come by from bank accounts and fixed interest, many investors are turning to investing in the stock market and, in particular, investing in companies that pay high dividends.
This can be a good strategy. However, there are some pitfalls you need to be aware of before you dive in head first, looking for the highest yield you can find! In this article, we’ll explain what to look out for when looking to invest in dividend-paying companies, and we’ll answer the question, is dividend investing worthwhile?
One of the ways you can earn a return as a company shareholder is in the form of dividend payments. These are paid as a share of the company’s profits, which you are entitled to as a part-owner of the company.
For example, if Tesco makes a profit of £750m in one year, they may keep £250m aside to reinvest in the business and then pay the remaining £500m out to shareholders as a dividend. This will be paid on a per-share basis, which means that the more shares you hold, the bigger dividend you receive.
Dividend investing seeks to find companies that pay high dividends with the aim of generating returns from consistent dividend income rather than expecting large capital gains. This form of investing can sometimes be considered a lower risk approach to the stock market, as companies that pay good dividends are often (but not always) large, secure, stable businesses.
With that said, it is easy to fall into the trap of just trying to find the companies that are paying the highest dividend. This is often expressed as a percentage of a share price. If a company with a share price of £1 is paying a dividend of 5p per share, this would be a dividend yield of 5%.
The average dividend yield on the UK stock market is around 4%, so looking for companies that pay more than this can seem like a really good idea. However, dividend yields can actually be a bit of a warning sign if they get too high. Paying out good dividends is one thing, but these dividends need to also be consistent and not put the long term stability of the company in danger.
After all, if a company is paying out a 10% dividend but isn’t leaving itself with any cash to run the business, the share price could easily fall as the company struggles. This could wipe out the dividend you received and then some!
As well as dividend yield, it’s important to look at where that dividend is coming from. Is it sustainable? Has the company profit come from regular business, or have they recently sold off assets? Are they receiving government grants which are boosting their profits? All of these questions need to be considered when looking to invest in a company for its dividends.
A really high dividend yield could also be a sign that the share price has dropped since the last dividend was paid. Again, it’s important to look at the dividend yield as part of the bigger picture of a company in order to decide whether it makes sense for your portfolio.
Yes, dividend investing can be a worthwhile strategy for consistent returns over the long term. That’s not to say that you won’t experience volatility in a dividend-focused portfolio, you will, but you are likely to hold a greater percentage of stable, “blue chip” companies.
As with any investment, diversification is essential. There are many funds and ETFs available to investors that focus on investing in high dividend-paying stocks. This can be a great way to outsource the research to a professional investment manager and gain access to a much greater level of diversification than you’re likely to be able to manage yourself.
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