A common problem I find when reviewing an investment portfolio for a new client is that there is an over reliance on dividend paying stocks or funds.

There is a misconception out there that if you pick an investment paying good dividends then you can use the dividends as your income in retirement and you don’t need to sell any shares or units.

The underlying capital remains untouched during your retirement.

It sounds good in theory, but the problem is what happens to the underlying value of those shares or units in real terms once you take into account the impact of inflation.

The Association of Investment Companies (AIC) keeps a list of investment trusts that have consistently increased their dividends for 20 years or more in a row. They are labelled ‘dividend heroes’.

At the top of the table at the time of writing there are investment trusts like the City of London Investment Trust that has increased their dividend every year for the last 57 years in a row!

An investment trust is a fund similar to the more common funds found in pensions like an open-ended investment company (OEIC) or unit trust but with a few differences.

The main difference with an investment trust is that it is closed-ended. Shares of the trust are traded on an exchange and the price of these shares doesn’t always reflect the value of the underlying companies it is invested in.

Whereas an OEIC or unit trust are open-ended meaning units are created or disposed of when investors buy or sell.

The other big difference is that an OEIC and unit trust has to pay out all of the income it generates to investors. An investment trust can hold back up to 15% of the income it makes which it can then use to maintain or increase dividends when markets might be in a bad place.

Dividend investors will focus on something called the dividend yield.

A dividend is the share of the profit a company makes. It’s often referred to as a yield, so it is easier to compare to other types of investment.

The yield is the dividend divided by the share price.

Or rent divided by the property price.

Or interest earned divided by the amount you have in savings.

The yield is going to be a very important number in this game because if someone is paying a good level of dividend you might have to pay a high price for it meaning you are more exposed to potential falls in value.

The problem with focusing on dividends alone is twofold.

Firstly, if the dividend yield is high, it could be that the underlying companies are not valued or rated very highly so future returns for the underlying capital could be lower. Causing issues with falling capital in real terms.

Secondly, a fund with a good underlying investment strategy may produce greater returns for the underlying capital but the yield will likely be lower at the start.

Dividends are really important in any investment strategy.

Take the returns of the FTSE100 UK share index.

The return over the last 10 years just focusing on price alone is 21.85%. If we add in the dividends produced it takes the total return to 79.05%.

Dividends re-invested means dividends earned can buy more units in a fund.

So, the better approach to take, even for retirement income, is to focus on TOTAL RETURN.

Don’t worry about selling down units because if the performance of these units is better you won’t need to sell down as much.

Remember you need inflation beating returns to increase your purchasing power because that’s what money is at the end of the day, purchasing power.

Focusing on dividend paying stocks or funds means you are concentrating your investment into certain areas of the market.

Higher dividend paying companies tend to be more established and not focused on growth as they are returning all the profits to shareholders rather than re-investing it to grow the business.

You need to ensure you are well diversified and capturing the global market return.

This could even be done with one fund nowadays.

The MSCI AC world index has achieved a return of 539.03% over the last 20 years. Five times the rate of inflation.

So, you need to focus on inflation beating returns, not income.

Remember a £1million investment today generating 5% income (£50,000) per year is not going to be worth £1million in 10/20 years’ time if returns don’t beat inflation.

You’re not going to be able to buy as much and your kids might not be impressed with their inheritance!

#dividendincome #liveoffdividends #retirementincome