Dividends: the one thing you can’t ignore if you want to make money in stocks

published 29 February 2016

160229-cash — Dividend-focused investing means small amounts of money rolling in month after month

Want to get rich from stocks?

People love to focus on dream companies like Apple or Asos, that go from zero to hero. But making money from shares isn't about sticking all your money on one horse and hoping it'll be the one in 10,000 that pulls off Apple-style returns.

The good news is, it's a lot less stressful than that. You don't need to pick out the one big winner. That's more likely to leave you broke than wealthy.

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Instead, you save as much as you can, keep doing it regularly, build it up over the years, and by the time you retire, you should be pleasantly surprised by what you've got in your pot.

You don't even have to spend hours a week poring over the state of the markets. In fact, you don't have to pay much attention to the financial press at all. You can ignore the talking heads and ignore the constant, panicky headlines.

However, there's one specific thing you can't afford to ignore

The power of dividends

If you want to make money from stocks in the long run, you need to pay attention to dividends.

There are a couple of reasons for this. Firstly, as the Credit Suisse Yearbook and every other long-term investment study constantly points out, the vast majority of the returns to long-term investors come from reinvesting dividends regularly.

If you'd stuck £100 in the stockmarket in 1900 and relied on capital gains alone, it would now be worth £240 (after accounting for inflation).

Want to know what it would be worth with dividends reinvested? A staggering £44,500 (again, after inflation).

Secondly, dividends are a lot less volatile than share prices. The biggest problem with the stockmarket is that the value of shares goes up and down a lot more than just about any other asset. They're more volatile.

Getting away from the City jargon, in the long run, shares tend to make you more money than anything else. But along the way, they'll give you a few near heart-attack moments.

The nice thing about dividends is that they add a touch of stability to all that. Don't get me wrong, they still go up and down companies don't have to pay them, and, as recent experience shows, when they run into trouble, the dividend is on the line.

But overall, dividend payouts fluctuate a lot less than share prices themselves.

So dividends matter. A lot.

And one man I know understands how to take advantage of the power of dividends more than pretty much any other investor I've met.

You might have received an email from him yesterday, but in case you missed it, I want to talk you through his strategy again today. (Or you can skip straight to it now, if you'd prefer.)

I don't normally do this, but I think that this particular strategy is of so much potential use to such a large proportion of our audience, that I'd be doing you a disservice if I didn't make sure I'd brought it to your attention.

Why does this simple strategy work so well?

My colleague Stephen Bland focuses entirely on buying stocks for their dividends. He doesn't worry about what's going on in the wider market. He just finds big stocks, with decent yields, and builds portfolios of 16-20 stocks. And he almost never sells.

It sounds ridiculously simple. It is. And yet it works.

I've spent a lot of time pondering the success of the strategy, and to me it boils down to a few key points.

Firstly, this strategy is naturally contrarian. By looking for stocks that have a higher-than-average yield, you're not going to be buying into "bubble" stocks. So you're always tending to go against the grain, and delve into the cheaper side of the market. And that's generally a healthy thing for investors to do.

Secondly, it's easy to implement. My biggest bugbear with many otherwise sound investment strategies is the amount of maintenance they require.

I've written many times before about how the average investor is their own worst enemy. We're easily distracted, we're easily derailed, we're apathetic, we're prone to bad habits all things that make complicated strategies almost impossible to stick to over the long run.

Stephen's strategy avoids all that. It's simple to set up and simple to stick to and because it's dividend-focused, you are constantly seeing the benefit of that, as small amounts of money roll in consistently, month after month. So you've got that positive reinforcement to keep you on track.

What about dividend cuts?

That's all very well, you might be thinking, but it's been a brutal year for income investors. We've seen plenty of high-profile FTSE 100 companies cut or freeze their dividends this year, from BHP Billiton to Rolls-Royce. And other sectors look under serious threat, including the oil majors.

That's scary, particularly as The Economist points out when roughly 70% of all dividends paid out from the UK market come from just 20 stocks. So what do you do to shield against dividend cuts?

Well, the first thing to remember is that although 70% of dividend payments might come from just 20 stocks, that doesn't mean there are only 20 dividend-paying stocks in the market. It just means that in absolute terms, the biggest stocks pay out the most money.

So while that might be a bit of a worry for the massive institutional income funds out there, for an individual investor there are still plenty of dividend payers available to choose from.

So rather than spending too much time worrying about which companies might cut their dividends, you should focus on diversification.

Mining stocks are having a hard time right now, no two ways about it. But rather than fretting about which one may or may not cut its dividend, you just make sure that your portfolio isn't all invested in that sector.

Various studies have shown that you only need around 16-20 stocks in a portfolio to get the most benefit from diversification. So you hold one miner. One builder. One bank. One pharma company you get the picture. Even when one sector or stock is struggling, it'll only ever account for a small proportion of your portfolio.

So: hold a concentrated but diversified portfolio, and reinvest your dividends. (Until you come to retire of course, at which point you can start taking all that lovely hard-earned dividend income out of the portfolio.) Sounds like the ideal income fund to me.

So seriously, if you haven't already given it some consideration, you should take a look at The Dividend Letter here.

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.