Your two-minute guide to dividends

Dividends can be the secret weapon in the investor’s armoury. What are they, what are the benefits and drawbacks, and – most importantly – what role can they play in your portfolio overall? Here’s a quick introduction to these tantalising payments. Article by Nick Green.

When you’re new to saving and investing, there seem to be two main avenues for growing your money. You can take the low-risk option of cash savings, where your money sits in a bank account for years accumulating interest. The disadvantage here is that when interest rates are very low (like now) this can require the patience of a saint.

The most obvious alternative is putting money into equities, i.e. stock and shares. This involves higher risk, but the principle is simple: if share prices rise, your investment gains value too (of course, the opposite also applies).

However, there is a second advantage to holding some types of shares, and one which is often overlooked by novice investors. Some shares, in addition to gaining (or losing) value with the value of their company, also entitle shareholders to receive extra payments. These payments are called dividends.

What are dividends?

A dividend is simply a portion of a company’s profits that is ‘divided up’ among some or all of its shareholders. Companies may pay dividends at any stage of their development, but the practice is most common among those that have passed beyond their fastest growth phase. This is the point at which some shareholders might get itchy feet, because their shares (which have been rising steadily in value) may now appear to be treading water. So, in order to keep those shareholders on board, the company pays them dividends so that they can still make money from the shares they own. The practice of paying regular dividends also makes shares more attractive to investors – which in turn fuels demand for the shares and ideally raises the share price. So everybody wins (at least in theory).

The amount paid as a dividend is entirely up to the company, provided it has sufficient post-tax profits to make the payments. The size of the dividend relative to the share price is known as the dividend yield; for instance, if the share price is £10 and the dividend is £1, the dividend yield is 10 per cent. The payment is made per share, so the more shares you own the more dividends you receive.

There are a number of different types of dividends, the main categories being cash dividends and stock dividends. As the names imply, the first kind is simply a cash payment, while stock dividends are paid in the form of additional shares in the company.

The attractions of dividends

As noted above, the companies most likely to pay dividends are those whose growth and hence share price has largely stabilised. This can make their shares less risky than those of companies in their early growth phase. Shareholders can therefore be more confident that their core investment is less likely to fall suddenly in value, while still receiving a consistent return. At the same time they will continue to benefit from any underlying growth, which may also increase the value of the dividends paid out.

Dividend stocks can therefore be a good choice for investors with a medium-high risk profile, as they can offer stabler returns than fast-growth companies, while being higher risk than bonds or cash investments. Companies that pay out a regular and largely predictable dividend may be particularly attractive for those seeking an income in retirement, where the regularity of income is more important than investment growth.

Another big attraction of dividends is that they are taxed at a lower rate than ordinary income. This makes them a popular choice for business owners who want to take an income from their business, as they can pay less tax on dividends than they would on a salary.

Drawbacks of dividends

At first glance dividend stocks seem to hold all the advantages: they are generally less risky, they may pay more predictable returns, and they help to boost the company’s share price. As ever, the reality is not quite so straightforward.

Lower risk does not mean low risk – these are still equities, which are classed at the riskier end of investments, and subject to falls in value or even total loss in extreme insolvency cases. Dividend stocks also tend to show lower growth than other stocks, so even generous dividends may not deliver the level of returns you are looking for at that level of risk.

Another thing to bear in mind is that nothing is guaranteed – just because dividends have been paid in the past does not mean that any more will necessarily be paid. The company’s performance is the key here: dividends can only be paid out of profits (or else they are illegal). If no profit is being made, your investment will just sit there failing to deliver returns (and probably losing value too).

Share prices can also fall even in a dividend-paying year, so the loss of value on your shareholding may cancel out your dividend payment, or even exceed it.

Deciding how to weigh up the risks and rewards is a critical part of your decision as to whether these stocks are right for you.

Fitting dividends into your investment strategy

The prospect of dividends may be an important factor in your decision about whether to invest in the stock market, and also what kind of stocks to invest in. They can enable you to continue to make money from shares where the company itself is no longer growing significantly, and as such they had an extra string to the investor’s bow.

Remember that the information given here should only be used as rules of thumb. Some companies in the early, fast stages of growth may buck the trend by paying dividends, just as some mature dividend-paying companies will not necessarily be lower risk. When picking stocks, you need to consider each one individually on its own merits.

The final tip – which should be obvious – is to keep any shares (dividend-paying or otherwise) in a stocks & shares ISA as far as possible, to minimise tax. Dividend income is not totally tax free even in an ISA, but you receive a £5,000 tax-free allowance, after which dividends are taxed at the rates shown on the HMRC website.

Talk about your investment plans with a financial adviser.

Nick Green is communications manager at Unbiased, the UK's favourite place to find advice you can trust. He has been writing professionally on finance, business and many other topics for over 15 years.