They can give you a steady income and boost your returns while also helping mitigate risk – but many savers overlook the advantages of dividends.
Dividends come from companies that reward shareholders with regular payments throughout the year. Typically, this cash is tied to the company’s profits, but it can also come from their reserves. While dividend payouts have dropped off this year, UK companies paid out £92.1bn in dividends in 2024, having hit a record high in the second quarter of the year. The FTSE 100 has delivered an average dividend yield of 3.9% a year over the past 15 years, according to AJ Bell, significantly higher than indices including the S&P 500.
So with demand for investment income as strong as ever, what should you know about dividends and how they affect your investments? Here are five reasons why dividends are so important, particularly for long-term investors.
Outperformance
Dividends are a big part of the returns we get from investments, and they can also be an indicator of a company’s financial strength. This is because companies that can continue paying dividends to shareholders on a regular basis could be seen as having a solid cashflow, a good level of stability and an ability to withstand volatility.
Dividend-paying stocks historically account for some 40% of returns from the FTSE 100, when reinvested dividends are included, while dividend payments from UK listed companies have grown by an average of more than 4% a year over the past 10 years. Over in the US, dividends accounted for a massive 40% of the total return from the flagship S&P 500 index between 1930 and 2021, due largely to what happens when they are reinvested…
The magic ‘snowball’ effect
Perhaps the most powerful argument in favour of holding dividend-producing stocks or investing in income funds is that dividend income fuels the compounding effect. This is what happens when dividends are reinvested rather than being taken as profits, as it means the dividends themselves will then grow.
For instance, say you invest £10,000 into a stocks and shares ISA that gives you annual growth of 6%. If you take the annual growth as profits each year the ISA will still be worth £10,000. But if you keep that growth in the fund each year and reinvest it, your original £10,000 investment would more than double in value to £20,000. And over the longer term the snowball just gets bigger: Keep reinvesting the annual growth over 40 years and your £10,000 would be worth more than £92,000.
Here’s more on how the power of compounding can help make you rich.
Regular income
Dividends provide a regular source of income, especially those wanting consistent returns on their investments and retired investors seeking a ‘natural’ income from their portfolio. Dividends are usually paid out once a quarter, though some are six-monthly or annual and a small handful pay out monthly.
Investment trusts can be especially useful here, as they are allowed to retain up to 15% of annual earnings in reserve to be able to keep paying dividends during leaner times. This mechanism has enabled 20 investment trusts to increase their dividends each year for 20 years or more, according to the Association of Investment Companies, with several doing so for more than 50 consecutive years.
Risk mitigation
One lesser-known benefit of dividends is that they provide a cushion against the worst effects of stock market volatility. This is partly because companies able to maintain dividend payouts tend to be established businesses with resilient balance sheets and cash flows, especially when borrowing costs (in the form of interest rates) are high.
More broadly, the steady return that dividends provide can keep long-term growth on track when markets are volatile. The knowledge that dividends are still being paid even as the value of a stock or fund fluctuates can also give investors useful peace of mind.
The pound-cost averaging perk
When we reinvest dividends over time we can benefit from what’s known as pound cost averaging. This is what happens when we use our dividend income to reinvest at different prices as markets move up and down. It means that you buy more units of investments when prices are low and so get extra profits when prices rebound, allowing you to bolster your long-term returns while riding out the short-term bumps.
It’s not all good though…
Dividends are never guaranteed, and even regular payers can suspend their dividends if the company is struggling or markets experience severe or prolonged turbulence. It’s also worth noting that if your portfolio focused only on dividend-paying companies or equity income funds you’d have a bias towards larger businesses with bigger reserves, meaning you may miss out on smaller companies with the potential for more rapid growth.
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Photo by Roland Horváth on Unsplash
