Readers of the Sunday papers’ financial pages will be familiar with the dividend chasing stories that pundits and some fund managers love to peddle.
These generally focus on high dividend paying shares or ‘income’ funds that focus on these shares.
The thought that one can take an income from a portfolio without the need to sell shares can feel appealing to some. But dig a little deeper and it quickly becomes evident that a portfolio constructed from a bottom up dividend-driven approach is unlikely to be the most optimal approach and contain risks that may not be fully appreciated.
The first point to note is that you cannot have your cake and eat it!
If a company pays out a high dividend, that money cannot be reinvested by the firm to deliver higher future earnings which in turn drives share prices - in other words, the present value of future cashflows of a company.
So, with higher dividends today, you forgo tomorrow’s price growth.
In theory, the dividend policy of a firm should make little difference to its total return (by total return we mean, dividends plus share price appreciation) .
The second point to note is that different sectors of the economy tend to have different average dividend payout strategies.
For example, tech companies tend to reinvest most of their cash flows into product development and attaining greater market share, whilst energy companies – operating in a more mature industry - may not be able to find projects in excess of their cost of capital and may return money to shareholders via dividends.
Chasing dividends tends to end up in large sector ‘bets’ away from the market.
The third point to note is that because each equity market reflects the companies listed on it, large sector differences do exist between markets.
For example, the UK has materially less exposure to technology companies compared to the US but higher weightings to energy companies.
As a consequence, the UK market has a higher dividend yield than the US market.
A dividend-driven approach will likely overweight the UK (and other higher yielding markets) relative to other lower-yielding markets.
If we look at the average dividend yield of the 10 largest global markets by size between 2015 and 2023, we can see that Switzerland leads the way, followed by Australia and then the UK.
The final points worth noting are: within each market, dividend payments are often concentrated in just a few shares resulting in share concentration risks; and higher dividends tend to describe value companies which are less healthy companies with higher expected returns, potentially inadvertently skewing a portfolio towards higher expected risks.
If you have bonds in your portfolio, chasing higher yields from lower quality bonds or lower quality borrowers), this simply adds equity-like risk to your portfolio.
The higher the yield, the riskier the borrower. But that story is for another day!
An eminently sensible alternative approach to taking income from a portfolio is to think on a ‘total return’ basis where an investor is agnostic to taking dividends or selling shares to deliver the capital required.
This is the way that pension plans and endowments tend to draw income.
It allows you as an investor to maintain the structural integrity of their portfolio and to avoid company, sector and market bets in the pursuit of higher dividend yields on portfolios.
My advice is, don’t cha
Find all our useful links on our LinkTree - https://linktr.ee/jonathangibson
And why not visit us at: https://www.wellsgibson.uk/
And get a copy of the book, Purposeful Wealth here: https://www.amazon.co.uk/Purposeful-Wealth-Contentment-Certainty-Financial/dp/B08T42FNGM