If you rely on dividends to fund your retirement or deliver an additional income stream, seeing companies reduce or pull their dividends can be alarming.
Yet a decline in dividend income needn’t be as concerning as it may seem. Here, we explain why taking a ‘total return’ approach to investing could offer far more flexibility when drawing income from your investments.
Investing for income
There are two ways to make money from investments: through a capital gain as its price increases, and through dividends or interest.
Many investors seek to draw income from dividends alone and leave their capital intact. For retirees, the argument is that this reduces the risk of running out of money, allows them to pass on wealth to future generations, and avoids having to sell investments that have fallen in value.
However, over the past few years, it has become increasingly difficult to generate a high income from dividend-paying investments alone.
Another option is to take a ‘total return’ approach, where you combine dividend income with capital gains. You essentially view dividends, interest and capital gains as the building blocks of your income stream.
Danger of relying on dividends
Relying on a slice of company profits to provide an income stream can be risky. Income from dividends is not guaranteed, and it can be volatile.
There have been several instances throughout history when companies have cut their dividend payouts. For example, over the 12 months to March 2021, UK dividends declined by 41.6% as two thirds of companies reduced or pulled their dividends during the Covid-19 pandemic1.
Bear in mind that an investment with the highest dividend yield won’t necessarily be the best investment. Dividend yields are calculated by dividing the dividend per share by the price per share. If the price of the stock falls and the dividend remains the same, the dividend yield will rise. Yet a falling stock price could indicate the company is in distress.
Dividend yield is just one of many factors to look at when assessing a stock or fund’s investment case. Sometimes, a stock might have a high dividend yield which is not sustainable. If it is forced to cut its dividend, this could result in its share price plummeting, meaning you could be hit with a double whammy of a capital loss and lower dividend income.
Benefits of total return
Taking a total return approach enables you to construct a portfolio from across the whole investment universe, and choose investments that are expected to give the best overall performance in line with your capacity for investment risk.
The main risk of using a total return approach is being forced to sell investments that have fallen in value. However, the intent is that by investing across a broad range of investments, as opposed to just income-producing ones, this should enhance your portfolio’s overall returns and reduce volatility.
Maintaining a diversified portfolio of investments that suits your individual needs and goals isn’t always easy, and that’s where getting some smart advice comes in. A financial adviser will help you feel confident you’re doing the right thing with your money, so that you can enjoy life now without worrying about running out of money in the future.
The value of investments, and any income from them, can fall and you may get back less than you invested. Neither simulated nor actual past performance are reliable indicators of future performance. Performance is quoted before charges which will reduce illustrated performance. Information is provided only as an example and is not a recommendation to pursue a particular strategy. Information contained in this document is believed to be reliable and accurate, but without further investigation cannot be warranted as to accuracy or completeness.