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Are dividends a good hedge against inflation? With the CPI (Consumer Price Index) standing at 9% in April 2022, many investors are looking for ways to protect their real returns. Dividends have been hailed by some as a viable way forwards. In this article, we explore the nature of “income investing” and whether it can boost your returns in a high-inflation environment. We hope this is helpful to you. If you want to discuss your own financial plan with us, please contact our team for more information or to access personalised financial advice:
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What is income investing?
Broadly speaking, there are two primary investment strategies: growth investing and income investing. The first prioritises investing in companies which often do not pay a high dividend (or even one at all), but which reinvest profits back into the business. Over time, the aim is for the company to grow the value of shares – allowing investors to sell them later, at a profit. The second approach focuses on investing in companies which are not primarily seeking to grow, but rather distribute their profits to shareholders as a dividend. Given enough volume, these dividends can provide a form of “passive” income for investors.
Here, the concept of dividend yield is important. This encapsulates dividend value by expressing it as a percentage of the present company share price. If, for instance, a company is trading at £10 per share and the company pays a £2 dividend, then the yield is 2%. As a general rule, a 2-4% yield is considered a “strong” dividend. However, the higher the yield the riskier the investment tends to be.
Why is income investing popular in 2022?
Dividend-focused funds have received increasing attention in 2022 for at least two reasons. Firstly, many funds dedicated to growth have struggled. Leading indices in the western world have fallen and brought tracker funds down with them. The S&P 500, for instance, has dropped -22.90% since January and the Dow Jones Industrial Average (DJIA) is also down by 17.75%. Secondly, inflation is standing at its highest level in 40 years. This erodes the real returns from asset disposals. For example, if you generate a 10% return on a stock but inflation is at 9%, then your real return is only 1% (without even counting taxes and investment fees).
Income investing has been presented as a way for investors to maintain progress towards their financial goals – at least in the short term. This is partly because dividends provide a level of comfort. Who doesn’t like to receive regular payments for very little effort? Yet there is also an argument from price stability. Since many dividend-paying stocks come from companies that have already achieved most of their growth potential, they tend to be less volatile than their growth-oriented counterparts.
Are dividends a good inflation hedge in 2022?
Since inflation is running so high in 2022 (9%; possibly rising to 11% in the autumn), investors should recognise that all asset classes are struggling to generate a meaningful return in the short term, at the moment. The 10-year UK government bond (gilt), for instance, currently offers a 2.62% yield. The S&P 500, which has historically returned an average of 10.5% per year since 1957, beats current inflation in real terms but the market is down since January. Cash is also a poor place to store large amounts of wealth over the long term, with the average UK regular savings account (fixed rate) offering 1.75%.
As mentioned above, a good dividend fund might offer a yield of 2-4%. There are certain stocks and funds that offer a higher yield, but many of these involve higher volatility risk. Therefore, “cautious” investors considering investments with a double-digit yield should take note that they may not reflect your risk tolerance. Moreover, bear in mind that dividends are never guaranteed. Companies are within their rights to suspend or scrap them if they deem this necessary to keep their financial position intact (e.g. during a recession).
Ultimately, therefore, investors should come back to their long-term strategy. How much risk are you prepared to take? How much do you want your portfolio to grow over the next 10-20 years? Have you been investing primarily for growth or for income, when the UK’s inflation rate still sat closer to the Bank of England’s 2% in 2021? When will you need to access the capital in your portfolio (e.g. for retirement)? Answering these questions is more important than trying to find ways to beat inflation with your investments in the short term.
Of course, we understand that it may be unsettling to see your portfolio returning less than the UK’s high inflation rate right now. However, bear in mind that the situation is unlikely to continue for a long time. Between 1960 to 2021, the average UK inflation rate was 5.1% per year. Since 1997 (when the Bank of England became independent), moreover, the average has been close to 2%. Investors should, therefore, be careful not to change their entire long-term investment strategy to beat an inflation rate that is unlikely to persist for long periods.
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