Seeking to add a relatively stable asset to your investment portfolio? Consider purchasing stocks in companies that pay dividends – portions of profit shared with stakeholders on a set basis, usually quarterly. These regular returns can help shore up your savings, but like any investment strategy, there are pros and cons to putting your money into dividend stocks.
The pros of dividend investing
Steady income stream
One of the primary attractions of dividend investing is the ability to generate a consistent passive income which offsets the unpredictability of returns from more volatile assets. You should opt for companies with a history of reliable payments such as those within the FTSE 100 index for peace of mind.
Potential for reinvestment
Dividends have the flexibility to be used for long-term growth rather than as a regular income stream. You can choose to use your dividend payments to automatically purchase additional shares, compounding your returns over time. This is known as a Dividend Reinvestment Plan. Historical data has shown that dividend-paying stocks often outperform non-dividend-paying stocks over the long term, partly due to the power of compounding.
Tax benefits
For UK residents, dividends can be quite tax-efficient. The UK government offers a Dividend Allowance which allows individuals to earn up to £500 in dividend income tax-free (as of April 2024). Beyond this allowance, dividends are taxed at rates lower than regular income for basic-rate taxpayers.
Moreover, you don’t pay tax on dividends from shares in an ISA (Individual Savings Account) or SIPP (Self-Invested Personal Pension).
The cons of dividend investing
Dividend cuts
While dividends can provide a steady income, this is not a guarantee. Companies can reduce the value of the payments or eliminate dividends completely. Dividend cuts are common during periods of financial difficulty when the company needs to keep back more profit to stay afloat, as seen during the COVID-19 pandemic when many UK firms slashed payouts to preserve cash.
Furthermore, dividend-paying stocks can be volatile just like standard stocks, especially in companies in sectors sensitive to economic cycles and world events like energy or finance.
Limited asset growth
High-dividend-paying companies often have lower growth potential compared to those that reinvest profits into expanding their operations. This trade-off means that while you may receive regular income, the share price appreciation might be more modest.
For example, growth-focused companies in sectors like technology or biotech typically reinvest profits to fuel innovation, often resulting in higher long-term capital gains but poor dividends.
How to invest in dividends
To begin dividend investing, start by selecting the right stocks. Look for companies with a strong history of dividend payments, a sustainable payout ratio, and healthy financials. Check the sector and evaluate whether they’re more likely to invest in growth or their stakeholders.
You can use an online investment platform for stock trading to access real-time market data, make buying and selling decisions quickly and efficiently and monitor your assets in one place. As well as using these tools to monitor the markets, keep up with the latest financial news, looking out for anything which might devalue or endanger your dividend payments.
UK-based dividend-focused mutual funds and ETFs can offer diversification and reduce the risk associated with individual stock selection. Remember to regularly review your portfolio to maintain a healthy balance between income and growth.
