Could dividends be the secret power behind your investments?

Investor meeting financial adviser

Since December 2021, the Bank of England (BoE) has increased the base interest rate from 0.1% to 4.5%. So, with rates hitting their highest level in more than a decade, many clients are asking us if they should consider moving more of their portfolio to cash.

While cash is often seen as the safe and reliable option, as you read in one of our recent articles, high inflation can have a significant effect on the real value of your savings.

Indeed, research by pension provider Royal London revealed that a sustained inflation rate of 5% over 10 years could reduce the value of your £10,000 worth of savings by 34% in real terms, bringing its spending power down to just £6,564.

Meanwhile, there is a case to be heard for investing in shares that pay dividends, rather than moving your portfolio to cash.

So, if you are looking to mitigate high inflation and the cost of living crisis, read on to find out how taking advantage of the historic stability of dividends could be more beneficial to you than moving your portfolio into cash.

How interest rates and inflation have changed in the last 2 years

Latest figures from the Office for National Statistics (ONS) show that the UK’s inflation rate stood at 8.7% in April 2023. Back in March 2021, the rate was just 0.7%.

There are many contributing factors to the increased inflation rate, with the primary one being the soaring cost of energy. Already in huge demand following the start of the Covid pandemic, gas and oil reserves were put under further pressure by Russia’s invasion of Ukraine.

Additionally, the amount of grain available was also reduced, increasing demand and, as a result, pushing up food prices across the globe.

In an attempt to control inflation, the BoE has increased interest rates. The theory is that this encourages more saving, and reduces the demand for goods and services, thus slowing the rate of price growth.

For borrowers, rate rises signal higher expenses in terms of things like mortgages and loans. For savers, however, higher interest rates mean a better return on cash savings – a reason why many clients are asking us if now is the time to consider holding more cash.

Investing in shares that pay dividends could give you the chance to receive additional returns

When considering alternatives to cash – typically equity-based investments – the potential for a return of the share or fund price rises is often seen as the main advantage. However, it’s also important to consider the power of dividends.

Dividends are payments to shareholders from the profits a business makes, once all business expenses, outstanding taxes, and liabilities have been paid for. Many listed companies pay dividends to their shareholders.

Investing in shares that pay dividends means that, as well as the value of your holding increasing if the share price rises, you could receive additional returns in the form of dividends if the company posts profits and pays dividends to its shareholders as a result.

Dividends have proven to be more stable than interest rates paid on cash

The dividend yield measures how much a company pays out in dividends each year, relative to its share price.

For instance, if you’ve invested in a company that has a share price of £1 and a dividend of 10p per share, the dividend yield per share would be 10%.

Data from 7IM reveals that, between 1899 and 2022, dividend yields have been more stable than the interest rates paid on cash. While cash is seen as being reliable, meaning you know the return you are getting, the data suggests that this is only true in the short term.

As you can see from the graph below, the general performance of dividend yields since 1899 has been more stable than the cash interest rate, with far more severe fluctuations being seen in the interest rate for cash savings during the same period.

Source: 7IM

Businesses want their dividends to be as stable as possible

For big public companies, stability and consistent performance are incredibly important to them. After all, any dividends they pay out to shareholders are effectively adverts for how profitable and reliable they are. Many companies would do anything they could to avoid having to cut their dividend!

So, you can take advantage of that stable dividend yield by considering shares in such companies (and funds) as a potential alternative to moving your portfolio into cash.

Data suggests that, historically, equities have performed better than cash savings

Additionally, considering equities can also mean generating the potential for growth. While the 123-year average of dividend yields and cash rates is identical at 4.5%, with cash, that is your entire return. Your annualised return is the same as the average interest rate at 4.5%.

However, with equities, your return wouldn’t just be the dividend yield. You could have the chance for capital growth, too.

The table below highlights this, as it shows that the average 123-year annualised return for UK equities was 8.8%, which would include the 4.5% from the dividend yield as well as 4.3% from growth.

You can also see from the table below the difference in the return of £100 invested in equities and cash, considering both the dividend and growth in value, compared to the cash return.

Credit: 7IM

Reinvesting dividends could offer compounding benefits too

An additional benefit is that, if you reinvest the dividends you receive, you can take advantage of compounding. For example, if you receive a dividend payment, you could choose to reinvest that into more shares in that company or fund.

If they post further profits in the future, your holding could increase in value, and, as you own more shares or units, your next dividend payment could be higher too.

Get in touch

As with any investments, it’s important to be aware that there is always an element of risk, so speak to a financial adviser before you do anything. To find out more, please get in touch.

Email or call us on 01454 416653.

Please note

The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.

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