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How do you like the idea of investing your money and simply living off the income generated by your investments? Broadly speaking, this is the approach of “dividend” investing. It is not highly popular as an idea amongst younger investors, fuelled by YouTube channels speaking of FIRE (financial independence, retire early).
Yet is dividend investing an effective way to invest your hard-earned money? Moreover, is it realistic? Below, our financial planning team at Cedar House addresses these key questions. If you’d like to find out more or discuss your own financial plan with us, please contact our team for more information or to access personalised financial advice:
020 8366 4400 or enquiries@cedarhfs.co.uk
How does dividend investing work?
Let’s take a simple example. Imagine Company A asks you to invest some of your money. In return, they promise to pay you a regular share of the profits. This “dividend” may come once per quarter, for instance, and may amount to, say, about £25 for each payout. However, the precise amount may vary depending on the company’s performance.
Some years, you could receive more (e.g. if the business takes off). Other years, in extreme circumstances you may get nothing at all. This has happened during the COVID-19 pandemic, since many companies felt it necessary to hold onto more profits to help weather the economic downturn – rather than paying out the money to investors, as they normally would.
£25 per payout, of course, may not sound like much. Yet imagine you invested into hundreds or thousands of businesses like this (e.g. via special, dividend-focused funds). This way, dividends could add up to a significant income – perhaps even allowing you to stop working and live off of your investments indefinitely.
Dividend investing and capital growth
So far, this may sound very attractive. Yet your financial goals have a big impact on whether this is an appropriate investment style for you. In particular, one problem is that dividend investing can hinder the ability of your investments to grow. This is partly because companies which offer investors a regular dividend have less profit to reinvest into the business, allowing it to grow and increase the value of its shares. As such, if your main goal is to grow a pension pot over the next 30 years by (at least partly) investing in companies, then investing in dividend-focused funds may not be the best approach. If, however, your primary goal is to provide an immediate income stream via your equity portfolio, then it could be an option. There can be exceptions, of course. Certain companies or funds which offer a dividend may also hold out strong prospects for future capital growth. A financial adviser can help you survey the landscape in this respect and provide the information you need to make the most informed decisions.
Inflation & dividends
The point about capital growth is important, since the value of a dividend payout will not stay the same – even if the on-paper amount (e.g. £25) does not change. This is because inflation slowly increases the cost of living over time, thus eroding the spending power of each GBP you receive in dividends. Suppose, for simplicity, that inflation rises in line with the Bank of England’s (BoE) 2% annual target over the next 20 years. Also, let’s assume that you receive a steady £1,000pm in dividends over the same time. By the end of this period, your income may appear the same as it did 20 years ago, yet in real terms your income may have fallen by 40%. This is why it is so important to consider the long-term implications of your dividend investing strategy, if you want to explore this style of investing. Make sure you seek financial advice to ensure sustainability.
Is dividend investing realistic?
The answer to this question partly depends on two factors. Firstly, how much monthly dividend income are you aiming for, and for how long? The higher the amount and longer the investment horizon, the larger the investment sum you are likely to need. Secondly, how much risk are you willing to take? Certain companies may offer a higher dividend, for instance, but also come with a higher risk of not paying out (e.g. newer businesses with a limited track record).
It is important to have realistic expectations about dividend yields. Historically, a yield of 4-6% has been regarded as fairly good. However, in 2021 interest rates are very low and companies have restricted/cut their dividends to try and cope with the economic fallout from COVID-19 – even those with a strong track record, such as established banks. In such an environment, an investor may need to be prepared for yields as low as 2-3%.
This starts to shed light on whether dividend investing is realistic to live off. In short, the lower your expenses and the more you have to invest, the more viable it will be. Yet, for many people, the sums involved are likely to be unattainable. For example, if you want to generate £1,000pm in dividends in an environment where yields are 2%, then you may need £400,000 invested – or possibly even more. Those with that kind of lump sum ready to invest should consider seeking financial advice first. This will help ensure you make decisions which reflect your goals, improve tax-efficiency and ensure sustainability over the long term.
Conclusion
Interested in discussing your financial plan with an experienced financial adviser? Get in touch today to discuss your financial plan with a member of our team here at Cedar House via a free, no-commitment consultation:
020 8366 4400 or enquiries@cedarhfs.co.uk