The importance of dividends

December 24th, 2012

In October the International Monetary Fund (IMF) downgraded its outlook for the global economy as Europe’s debt problems, coupled with concerns over the US economy continue to contribute to the wider global economic fragility.  The Head of the IMF has stated that the problems of the developed countries (as the worlds largest consumers) is inevitably having a knock-on effect on the economies of (exporting) developing countries and putting the global recovery at risk.

So why the above preamble?  Well, understandably this creates an uncertain environment for investors as the above issues (and the fears of a UK (and indeed global) recession) continue to be reflected in volatile share prices and investment markets generally.

The typical and not unreasonable reaction from potential investors is to keep their money in cash or other low-risk assets until market conditions are more ‘favourable’ – but is a wait and see strategy necessarily the best option?

Dividends v capital value

Firstly, in no way does this article encourage all individuals to rush out to invest in stocks & shares or in funds which invest in the stock market – An investment portfolio should comprise a diverse range of assets and, indeed for some equity (share) based investments will not be suitable at all.  However it is worth re-emphasising the importance re-invested dividends can play in a portfolio.

Consider the following table which shows a comparison of the FTSE100 with and without dividends over various timescales– A key thing to remember is that the headline movements in index levels reported in the news reflect fluctuations in the capital value of the shares comprising the index, in other words the changes in the share prices.  This doesn’t take account of any dividends or charges.

Index

Performance

1 Yr 3 Yr 5 Yr 10 Yr Since Launch
FTSE 100 +  9.6% +12.6% -12.2% +  55.3%   481.0%
FTSE 100 (income reinvested) +13.8% +25.2% +  6.2% +122.7% 1038.5%

 

Source: www.trustnet.com.  Figures are cumulative performance for periods 09/10/2002 to 09/10/2012 (10Yr), 09/10/2007 to 09/10/2012 (5Yr), 09/10/2009 to 09/10/2012 (3Yr) and 09/10/2011 to 09/10/2012 (1Yr).

So from the above performance data £1000 invested 5 years ago would have fallen to around £878 today without dividends being taken into account, whereas the same investment would be worth around £1,062 accounting for reinvested dividends.

It should be stressed that the age old adage that you should not put all your eggs in one basket applies here, as it always should for prospective investors.  What the above data does show, however, is that (for investors with a longer-term investment horizon) including a reasonable proportion of funds that invest in quality higher-yielding companies as part of the equity element of a portfolio could be considered – this perhaps becomes even more relevant in volatile times when sustained growth in capital values cannot be relied upon as heavily.

Tax Wrapper

It is worth remembering that dividends are subject to income tax regardless of whether they are paid out to the investor or reinvested back for growth.   Whilst there is no further tax to pay on a dividend for a basic rate taxpayer, higher and additional rate taxpayers are liable to a further 22.5% and 32.5% respectively on the gross dividend.   Over time the cumulative tax paid on these income distributions can significantly affect the overall net return from an investment.

Whilst ISAs and pensions provide a shelter from additional income tax, any dividends received from direct investments (e.g. – Unit Trusts) will be taxable and therefore another consideration for individuals subject to higher rates of income tax is choosing the most tax efficient vehicles for funds with higher income (dividend) yields – For example an investment bond may be appropriate when allowances for other more tax efficient investment wrappers such as ISA’s have been fully utilised

Summary

As you can see dividends can play a very important part in the growth of your investments and the concentration on share/unit price increase is not always an accurate measure.   Investment in a high yielding low growth stock can produce greater overall returns than a pure growth but volatile one.  The difficult aspect is choosing the right holdings.

As previously mentioned it is important to have a balanced portfolio which comprises a range of asset types (e.g. – cash, fixed interest securities, equities, property) – The proportions you might invest in each area will be based on your circumstances, attitude to risk (and capacity for loss), and your objectives.   Indeed, for certain individuals, certain investments will simply not be appropriate for them at all due to the risks involved.  In addition the sheer number of funds to choose from makes seeking professional advice essential

We can help advise you on the best way of investing your money so please feel free to contact us to arrange a meeting if you are looking for further guidance.

The value of shares and the income from them can fall as well as rise and investors may not get back the full amount originally invested.

Levels and bases of and reliefs from taxation are subject to change and their value depends on the individual circumstances of the investor