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By: Tim Bennett
14.02.2020
14.02.2020
Background
Anyone looking to generate a decent yield from an equity portfolio may need to take a more creative approach than just banking dividends, as Tim explains.
The challenge arises when investors think in binary terms about how they will draw income from a portfolio once they start needing it. Some are tempted to target high income assets and hope to just draw down the income from them.
The problem with this approach is encapsulated in the “dividend puzzle” which suggests that investors may be overpaying for higher yielding assets and making the process of generating income pretty tough in the process.
The dividend puzzle
This is a well-documented observation that suggests that investors routinely overpay for income generating assets even when in purely logical and theoretical terms they should not. After all, it shouldn’t make a difference whether a firm pays say a 10p dividend per share and keeps back 90p for reinvestment (based on profits of 100p per share), or simply keeps the whole lot and pays a zero dividend. Why? Because an investor is getting the benefit of 100p per share of profits either way, with the only difference being the timing of when those profits are received in cash terms.
The key question is why they do this, to which there are several possible answers.
Some explanations
There are in fact quite a few studies that purport to explain this dividend preference. Three of the more influential ones are;
- The “bird in hand” hypothesis – this suggests that cash received now is more valuable than the promise of it in the future
- Signalling theory – this is the idea thar by paying a dividend, managers signal their confidence is their own cash management skills, something investors like to see
- Inefficient capital allocation risk – this theory suggests that whenever managers invest capital, they may do so in a way that is not fully aligned with their investors, rendering dividends a more attractive option
The upshot
Whatever the cause, the result is that dividend paying stocks can trade at a premium to their non-dividend paying peers. Inevitably this premium tends to attach to firms that are therefore quite mature and perhaps past their best growth phase. On top of this there is a tax risk.
Tax risk?
Another problem facing investors receiving large amounts of dividend income is tax. The dividend allowance has been reduced from £5,000 to £2,000 per year, whilst investors who focus too heavily on dividends may also sacrifice their capital gains tax allowance (£12,000 in 2019/20). In short, a high income may not be tax effective.
So, what is the alternative?
Another approach
Someone who is aiming to generate, say, 4% a year from their assets might consider splitting it down into income that is generated from dividends and income that is generated by selling a part of their portfolio on a rolling basis. The split could be anything – perhaps 2% and 2% – depending on their objectives and personal circumstances.
Advantages
This type of combined approach to income generation may make better use of tax allowances and offer the opportunity to invest a portfolio less conservatively, away from what may be a crowded dividend stock space.
To find out more
Please feel free to email me on [email protected] or contact an Adviser if you would like to know more about this topic.
