By: Tim Bennett
28.04.2017
28.04.2017
Tim Bennett looks at the pros and cons of shares as a source of portfolio income.
In a low-yield world, where can investors turn for a reliable income stream? With the right approach, shares can provide an answer in the form of dividends. Here’s a summary of their main advantages and risks as part of a balanced income portfolio.
A recap on dividends
Every year the directors decide what proportion of a firm’s annual profits they will pay to shareholders as a dividend. It is worth remembering that, although this decision needs to be ratified at an Annual General Meeting of shareholders, dividend policy is therefore in the hands of the directors. Typically dividends are paid in two tranches – at the “interim” stage, roughly half way through the financial year and then a top up “final” dividend. Whilst some shareholders eschew dividends in favour of stocks that offer capital growth, we think solid dividend stocks offer three advantages.
A decent relative yield
Thanks to record-low interest rates around much of the world, income has become tough to find. Nonetheless shares can still offer a reasonable amount of it, expressed as a yield (the annual return from an investment as a proportion of the capital invested at current prices). The following snapshot was taken in early April 2017 purely as an illustration;
You can see that a basket of UK shares – here the broad FTSE All-Share index – offered around 3.5% as an annual return versus 2.6% for corporate bonds, 1.5% for UK government bonds and somewhere just north of 1% for pure cash term deposits (depending largely on the riskiness of the deposit taker). What’s more, over the long-term dividends have tended to grow.
Steady growth
Income investors not only want a decent yield but they also need to see some growth in their income stream so that they at least keep pace with inflation. Shares have shown since the start of the century that they can offer long-term income growth as the following chart reveals;
Risk warning: your capital may be at risk when you invest in shares. Past performance is no guarantee of future performance
Here we can see that the annual income from a holding of the FTSE All-Share index has roughly doubled (from around £60 to more like £120) since the turn of the century (the pink area above). Meantime, the capital value of the same index has risen around 23% over the same period (the black line above). This trend shows that over the long-term dividends can offer income growth. And for investors who are prepared to leave their money invested, there is a third benefit.
The power of reinvestment
The final chart below compares the return from the FTSE All-Share on a capital-only and total return basis, where the latter includes reinvested dividends. Since January 2000 the total return has beaten the capital-only return handsomely, albeit this is no guarantee of future performance.
Risk warning: your capital may be at risk when you invest in shares. Past performance is no guarantee of future performance.
We’ll finish with another important caveat.
Dividend risks
As we noted earlier, dividends are determined by the directors. That means when times are tough the annual dividend can be cut or even suspended and sometimes at very short notice. Even firms the size of BP and Tesco have succumbed in the past which demonstrates that no share is immune to either price falls or dividend cuts, or both. As an investor, you need to be alert to this risk and adequately diversify an income portfolio to help to mitigate it.
