Everybody wants to get the greatest return possible from their investments in the stock market. Who wouldn’t love to see their shares double or triple in value? Although this may be the goal of investors, it is very difficult to achieve. One of the ways that investors can increase their chances of selecting winning investments is to invest in companies that pay dividends
What is a dividend?
A dividend is a profit distribution paid by a company to its shareholders. The profits may originate from normal company operations or from the organisation’s investment activities. The company’s board of directors determines and declares cash dividends periodically – typically on a quarterly, semiannual, or annual basis. They can be paid to shareholders in the form of cash or as additional shares, although share dividends are usually only issued when the board wants to reinvest cash profits to fuel future company growth
Why are they important?
Dividends provide income - retirees in particular love shares that pay dividends because of the consistent income that is paid out. Investors can count on stable dividend payments to help with their monthly bills. Dividends enable investors to receive some cash from their investments without having to liquidate their positions. (Or, if they don’t need the cash right away they can reinvest the dividends and take advantage of the power of compounding.) This income can add up to a sizable amount for an investor that owns a lot of shares
Dividends are taxed at a lower rate - regular income that is received from your job is typically taxed at a much higher rate than dividends. Dividend income is taxed at a substantially lower rate which means that you have to pay less to the government and get to hold onto more of your own money. The tax savings can be used to help your retirement account grow. Currently, dividend income at or below the £35,000 basic rate tax limit is taxed at 10%, dividend income at or below the £150,000 higher rate tax limit is taxed at 32.5% and dividend income above the £150,000 higher rate tax limit is taxed at 42.5%
Dividends add to the total returns of shares - one of the most overlooked aspects of dividend investing is the fact that dividends can increase your returns in the market. During difficult bear markets, dividends may be the only positive returns that your portfolio sees. A stock with a high dividend yield could easily add an extra 3% or more to your investment returns
Dividend shares outperform the market
Studies have shown that shares that pay dividends historically outperform shares that don’t over the long term. That’s because of the compounding nature of dividends. Dividends can be used to add more shares to your investment position which increases the total return of your investment
There’s no easy way to spot good dividend shares. As with all investing, you need to do some homework. You need to research the company you fancy investing in thoroughly. In particular, you need to find out:
- how long has it been paying dividends?
- what is the pattern - static, rising, falling?
- is the company generating enough cash to cover its debt?
- how is its cash flow? Does it have a solid reputation for maintaining the money pouring in? (research the evidence from, for example, the Financial Times’ website.)
- are company insiders buying shares in their own company? (a big plus, if they are)
- is your chosen company doing better than its rivals in the same sector?
Most long-term growth comes from reinvesting dividends into your portfolio. But it’s not risk free, and there are three assumptions that can be tested to destruction: stable dividend income; stable stock prices and stable economic conditions for the company.”
Now you can see why dividend investing is not just important to older investors but young investors as well. Dividends are an essential ingredient to improving your portfolio performance and creating additional income
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