Passive income is a dream for many. This is often linked to an early retirement and financial independence. And today I want to talk about the most passive way of making money – dividend investing.
I am not a financial advisor and the below is simply my views and experience in the field so far. I will share the reasons I like dividend investing, pros and cons I found with this as well as the way I pick my stocks.
Luckily for those who invest in the UK – FTSE 100 is full of great dividend stocks to pick from.
what are dividend stocks
I will start with the basics – what exactly are dividend stocks?
Any company that you can invest into will be one of the two – a dividend paying or non paying company. A dividend is a share of the profit that is paid to everyone who owns shares of the company on a specific date. This date is called an ex-div date.
Dividend payments are normally measured in percentage terms of the current price of the share. Let’s say each share costs £1 and a company pays £0.05 in dividend for each share – your yield is 5%. If the share price goes up to £2 per share – the dividend yield will drop to 2.5% unless the company decides to increase the actual cash amount of dividend it pays out.
With some of the better dividend companies out there – they have been paying dividends without reducing these for decades. The best companies are proud of actually increasing their dividend annually.
At this point you also probably wonder – why would anyone invest in a company that doesn’t pay a dividend? Isn’t that a simply lost source of income for you?
The answer to this is simple – some companies are using the money to reinvest into their business rather than pay dividend. The idea here is simple – invest back into the business to grow it and deliver more revenue and profit.
The above would result in the company becoming more valuable. This would then make the company shares increase in price quicker. These type of shares of companies are considered growth stocks.
why I love dividend stocks
There is a reason I love dividend stocks and it is simple. If you invest in the right company – you have secured yourself a source of income for a very long period of time. Don’t get me wrong – things can go south and dividend can get cut. That’s the reason you definitely need to diversify your portfolio.
The way I see dividend stocks – a source of income in the future. Something I would use for my retirement. This would be only a part of my overall portfolio.
Dividends that you can normally earn range from 2% to 5% depending on the industry an the exact company. Some companies will pay more or less. These in my view wouldn’t be your typical dividend shares. An alternative to this can also be the FTSE 100 itself. A broad market index. This currently pays roughly 3.7% annually.
One further reason I love dividend stock – you can lock your dividend yield whenever you wish. This will however be the yield to the purchase value rather than portfolio value. And this only applies to the instances when the dividend doesn’t get cut.
Once you purchase £1,000 worth of FTSE 100 that pays 3.7% yield – you will be earning £37 every single year for as long as the cash value of this remains. Even if the value of the index drops but the cash dividend remains unchanged – you will be getting your £37.
If the value of your invest drops but the cash dividend remains the same – yield you are earning goes up.
Average expected dividends will grow over time. This will make your investments bring more income as time goes on.
An additional benefit is compounding. Keep reinvesting your dividends while you are accumulating assets. This will make your passive income explode eventually.
what issues I see with these
There are some things I also consider to be issues when it comes to dividend stocks.
Firstly, most of the companies that are worth investing in for the long run use a large chunk of their profit to pay dividends. Yes – I see this as an issue. The reason I say this – instead of expanding their business and growing the bottom line to deliver more value appreciation, money is distributed to investors.
This in my personal view slows down the overall growth of the portfolio. There is an exception to this though. And that is when the markets are hit by uncertainty.
During long period of markets moving sideways – dividend stocks can be a great place for your money. The income you will get won’t match the high returns you can expect from growth stocks during rosy times however some income is better than no income in my view.
This is the reason I see dividend stocks a great addition to a diversified portfolio.
Second issue I see with dividend stocks are taxes you are expected to pay. 2022/23 tax free dividend allowance is £2,000. This unfortunately is being cut as of April 2023. The new tax free dividend allowance is £1,000.
This will make dividend investing significantly less profitable for many. There is however a way around this issue. Build your dividend portfolio in a tax efficient investing account. Here I am obviously talking about the incredibly powerful ISA accounts. There is no tax to be paid on dividends or asset value appreciation.
what stocks I choose for my portfolio
UK stock market is filled with great dividend paying companies. The list is really long.
There are some companies that are better than others in my personal view. 5 companies I would personally look into are:
All of the above companies are known to be reliable dividend payers. Yields on these vary from 2.5% to just over 5% at the moment of writing this article.
The key strength of these companies in my view – services and goods of these business are used by most people in the UK and globally. The revenue will keep coming in and there will be profit to distribute amongst all investors.
On top of the above – all of these companies have increased their dividend payments for at least 10 years in row. To make the deal even sweeter – the minimum dividend growth rate per year amongst these 5 companies is 5%. This means the income you will be getting will keep on growing.
In addition to the above businesses – I am also excited about the opportunities in banking sector. There has been a recent banking crisis in the US. This has resulted in major banks on the UK stock market loosing large chunks of value.
As a result the likes of Barclays, Lloyds and HSBC are currently offering dividends north of 5%. While there is a risk of things becoming worse for banking sector – for me personally this is a risk I am willing to take.
summary
Dividend investing is definitely a great addition to any diversified portfolio. When you start building your dividend portfolio – make sure you do so through a tax efficient account like ISA.
The dividend investing isn’t a get rich fast scheme. The success here takes a while and requires a lot of patience and emotion management.
Once you invest and start earning your first dividends – make sure these get reinvested at the earliest possibility. This way you will make your money work for you rather than sitting in your account and losing buying power due to inflation.