Friday 28 January 2011

Income from Shares (UK, US)

One source of income included in the DIY Income Investor approach is dividends from shares - those regular payments that many companies make to shareholders; their share of the company's profits. 

There are numerous academic studies showing the importance of dividends in stock market portfolio returns, and indeed showing that the shares prices of higher-yielding shares have tended to perform better.
The value of the dividend is usually compared to the share price as the yield, (total annual dividend divided by the share price) which is comparable with the rate of interest on a savings account. However, the share price may rise or fall, meaning that the dividend yield of a share is always changing - unlike the interest rate on savings.

The main risks with dividend investing are that:
  • the share price may falls consistently and significantly and you might never be able to sell the share at anything like the cost of buying it (e.g. in the UK - Northern Rock)
  • the company may reduce the dividend or even stop paying dividends altogether (e.g. in the UK - Lloyds TSB, BP, RBS)

A review of investing in high yield dividend companies from a US perspective is given here (although it is trying to sell a service that is not necessarily something you need to buy).

New investors may be safest starting with an ETF that specialises in companies with high dividend yields.

The remainder of this post is intended for those investors with some experience and who want to try to pick good individual dividend companies for their portfolios.

'Dividend investing' - establishing a portfolio of high-yield company shares - is a well established and tested strategy. The approach recommended for the DIY Income Investor is that developed initially by Stephen Bland at the Motley Fool called the High Yield Portfolio (HYP), described here (take a little while to read through it all, if this is new to you).

There have been a number of updates (here and here) but the basic idea remains unchanged.

There is also an active discussion board that will tell you all you want to know about the approach and the suitability of different UK shares for a HYP. The basic guidelines are:
  • to reduce risks, diversify with share holdings in different sectors of the economy (building up a portfolio of at least 10 and up to 20 shares)
  • choose only FTSE 100 companies (again to reduce risks)
  • generally leave the shares alone, once bought

For the individual shares that have to pass the following criteria:
  • yield higher than the FTSE 100 average: say more than 4%
  • a good track record of increasing dividends
  • low level of debt
  • dividend cover of at least 1.5 (i.e. their profits should significantly exceed the annual dividend bill

In a separate post we discuss Todd Wenning's (Motley Fool) Dividend Report Cards, which provide a good introduction for what to look for.
More guidance on developing a HYP is contained in another post on 'how to build a HYP'.

A High Yield Portfolio is not without risks; for example, a very high yield can be an indication of a company in difficulty (if its share price has been forced down but it has retained its dividend level - possibly at an unsustainable level). More analysis is obviously needed before selecting shares.

Of all the stock market investment strategies, a focus on dividends has the key advantage of ease of understanding and (relative) simplicity of implementation. It also offers the possibility of outrunning your greatest enemy as a DIY Income Investor - inflation.

It is worth recalling that, using the DIY Income Investor approach, the HYP is only one part of the overall Income Pyramid - and probably should account for  much less that a third of your total investments.

I am not a financial advisor and the information provided does not constitute financial advice. You should always do your own research on top of what you learn here to ensure that it's right for your specific circumstances.

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