By Alice Guy on March 17, 2022Reading Time: 4 minutes
Dividend income is the secret weapon of successful investing. Just like other passive income, it can fuel your investment wealth from the comfort of your armchair. But what are the secrets of successful dividend investors and how can you use dividend investing to supercharge your investment growth? Let’s cut through the noise and take a look at 3 truths and a lie about dividend investing.
Reinvest dividend income to maximise your investment returns
Focus on growth as well as income and diversify your portfolio
Stocks with a great dividend yield are not always a good buy.
Reinvesting your dividend income is like adding rocket fuel to your investments. An investor with a £100,000 portfolio who reinvests their dividends may see their wealth more than triple over 20 years, compared with another investor who withdraws their dividends. That’s due to the compounding effect of dividend income over a long period.
Here are the detailed figures: If you invest £100,000 for 40 years and reinvest your dividend income, your investment could grow to an enormous £1,889,663 (assuming 4% net growth per year and 3.37% dividend income).
That’s a ridiculous investment growth of around 1,789%. In contrast, if you withdraw your dividends, you would have an investment portfolio worth £493,987 after 40 years, growth of only 393%. This dividend snowball effect is why successful dividend investors can get so rich!
The FTSE 100 is full of generous dividend payers. In 2021 shareholders of energy giant BP enjoyed a dividend yield of 4.38% , whilst GlaxoSmithKline shareholders received a yield of 5.38%.
The secret power of dividend income is often hidden to investors because of how share prices are reported. If you look at a FTSE 100 chart it shows “price return” or share price growth, but the “total return” of the index is actually far greater once you add in dividend income.
In year the up to March 2022, the FTSE 100 enjoyed annual price growth of 12.34% but the total return, including reinvested dividends, was 16.43%.
But, dividend income is only part of the story – successful dividend investors also need to consider capital growth. If you just invest in high dividend stocks, you could miss some amazing investing opportunities. It’s sometimes worth chasing down stocks with great growth potential, even if they have a lower dividend yield.
As an example of that higher potential growth, the FTSE Small Cap index has grown 26.9% in the 5 years up to March 2022, whereas the FTSE 100 index is currently down 0.2% over the same period. Some FTSE Small Cap companies do pay generous dividends, but they tend to fluctuate more than those for larger companies. Smaller companies may decide to hold off on dividends and reinvest in the business to fuel future growth.
Opting for a diversified portfolio means you’ll invest in both high dividend stocks and high potential growth stocks, with smaller dividends.
For the ultimate lazy investing solution, you could pick a FTSE All-Share index fund. Your investment will be spread across the FTSE 100, FTSE 250 and FTSE Small Cap indices. You’ll get exposure to all the big dividend-paying stocks in the UK and smaller growth stocks for around 0.2% fund fees per year. When you select your fund you can choose the accumulation option and any dividend income will be automatically reinvested in new shares.
If you want to invest in small cap dividend stocks then it pays to check out their dividend history. Watch out because many small cap companies don’t pay regular dividends so they can reinvest their profits in the business.
Two dividend small caps that pay consistent dividends are management consultancy business Record and estate agent, Belvoir. Record enjoyed share price growth of 10.56% in the year up to March 2022, and had a dividend yield of 4.22% in 2021. Belvoir achieved share price growth of 33.95% over the same period and had a dividend yield of 3.75% in 2021.
No-one wants to see their hard-earned investment wealth eroded by tax. And, sheltering your investment wealth inside an ISA or pension scheme could help. It means you won’t pay any tax on your dividend income. You can contribute £20,000 per year to a Stocks and Shares ISA and up to £40,000 per year into a pension scheme.
From 6 April 2022, you’ll pay tax on any dividend income over £2,000 per year. The rates will rise to 8.75% for lower rate taxpayers; 33.75% for higher rate taxpayers and 39.35% for additional rate taxpayers. That means higher rate taxpayers will pay £2,700 tax on £10,000 dividend income.
Our calculations show that sheltering a £100,000 investment from tax for 20 years could save you around £42,000 in dividend tax. It could make a huge difference to your investment wealth over time.
And here’s a lie that could skew your investing choices and hamper the growth of your stock portfolio.
The lie is that stocks with a high dividend yield are always worth buying. It’s a lie because dividend yield can actually be deceptive and mask a company in decline.
A juicy dividend yield could hide a rotten core, as dividend yield can actually rise when the share price tanks. That’s because it’s calculated by dividing the dividend per share by the share price to give you a percentage dividend return.
For example, if a company pays a dividend of £5 for each share and its share price is currently £100, then the dividend yield is 5%. If the share price tanks and drops to £50 then the dividend yield would rise to 10%. The dividend yield looks great but the company might be on the rocks.
So, if you’re weighing up a potential investment, don’t just look at dividend yield. Take time to check out industry news and compare dividend yield with other investing ratios like dividend cover. This is a measure of a company’s earnings over the dividends paid to shareholders. A low dividend cover suggests a company may struggle to continue paying dividends at the same rate in the future.
Dividend income is the unsung hero of long term investing. It works secretly, quietly and often without even being recorded. As if by magic, your wealth will grow as you reinvest your dividend income in more and more shares.
Of course, investing success is never guaranteed. But, if historic returns are anything to go by, successful dividend investors can expect to see their wealth snowball as they get towards retirement. Start investing, keep investing, reinvest your dividends and then sit back and watch the magic happen.