Making Use of Dividend-Paying Shares

Portfolio Lesson 5.9: Why might you want to seek out dividend-paying shares?

Morningstar 15 July, 2010 | 10:29AM

This lesson will discuss why you might want dividend-paying stocks in your portfolio, and explore some popular dividend-based stock strategies. Catch up on previous Investing Classroom lessons in our Learning Centre.

A Little History
For most of the 20th century, the average dividend yield (annual dividend per share divided by price per share) was around 5%. But over the last 20 years of the 20th century, however, yields steadily fell.

Why the change? The bull market of the 1990s, for one. As a stock's price rises, its yield falls. So as the FTSE rallied during the decade, its dividend yield naturally shrank.

But appreciated stock prices aren't the only explanation for the market's shrinking dividend. Rather than pay their earnings directly to shareholders as dividends, companies have shifted towards reinvesting those earnings in their businesses and returning money to shareholders via less direct means, such as share buybacks. This shift was embraced by most investors as, at the time, dividends were less tax efficient than capital gains on investments. Tax regulations continue to change, however.

There are currently three different dividend tax rates in 2010-11, depending on your overall taxable income after allowances. At or below the basic income tax limit of £37,400 dividend tax is 10%, at or below the higher income tax limit of £150,000 dividends are taxed at 32.5%, and above this higher threshold dividend tax rises to 42.5%.

Capital gains tax, meanwhile, has recently increased to 28% from 18% previously for higher rate taxpayers, after an annual tax-exempt allowance of £10,100, and remains at 18% for basic level taxpayers. Therefore, whether you opt for investments that pay dividends or investments that result in capital gains depends on your overall taxable income.

Using Dividend-Paying Shares in Your Portfolio
There are good reasons why you might want to hold dividend-paying shares in your portfolio.

Dividends are generally more reliable than capital gains--you know exactly how much you're getting and when you're getting it. As a result, dividend-paying shares often perform relatively well in a volatile market. Dividend-paying shares are especially popular among investors nearing retirement who seek a stable source of income.

The most straightforward way to include dividend income in your portfolio is to buy shares with high dividend yields, or funds that buy dividend-paying stocks. Companies in certain industries, such as REITs, tobacco companies, and utilities, generally pay hefty dividends, and are a good place to look for high-yield stocks.

Beware, though: a very high yield often signals a risky stock.

Another option for dividend-hungry investors is preferred stock. This is somewhat like a hybrid of stocks and bonds. Like a stock, it represents an ownership stake in a company, but like a bond, it pays a fixed dividend (like the fixed interest on a bond) and its value is very sensitive to interest rates.

Most preferred stock used to have no expiration date, so that its owner could theoretically go on collecting dividends forever. Now, however, most companies give themselves the option of retiring preferred stock after 10 years or so, making these securities even more like bonds. Also, many companies now issue preferred stock whose dividend goes up and down with interest rates. Still, preferred stock is at least an option worth considering if you want a steady stream of dividends.

If you want to learn more about dividends, searching our article archive will result in a list of relevant articles such as:

Preferred Stock: The Worst of Both Worlds
A Dividend Pick in the Utilities Sector
Load Up on Yield with These Dividend ETFs
Should Investors Look to Asia for Dividend Yield?

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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