Explaining Dividends

Posted by E.A. Mann on May 1
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When you’re just starting out with investing, it can be difficult to know what exactly you’re supposed to be buying. All these terms come at you: diversification, index funds, bonds, large-cap securities. I use these terms so often in my writing that I forget how abstract they can all seem. What does it all mean? 

But in my experience, everyone understands dividends immediately. Partly because of this, new investors tend to prize dividend-paying shares 

A short explainer: a company with a dividend pays out real money to anyone who owns shares in their company. For example, Barclay’s Bank currently has a dividend “yield” of 2.97%. This means that for every £100 of shares held, the bank plans to pay £2.97 yearly. 

The idea of dividends are attractively simple. I own part of a company. That company made money. Therefore I get some money. It’s mine now, and no one can take it away from me. 

But there can be problems with chasing high-yield shares exclusively and here’s why: there is no magic to dividends. 

There are only so many ways a company can spend their profits: they can invest it back into themselves, for example, by hiring people or building factories, they can buy other companies, they can buy back their own shares which should generally cause their share price to go up, or they can give it out as a dividend. There may be others, but these are the big ones. 

Companies are not creating this dividend money from thin air. They are taking their own money and choosing to give it back to you instead of putting it to another productive use. This isn’t necessarily right or wrong. But of all the ways I listed to spend profits, only dividends have the potential to cost you money in taxes today. (Remember you don’t pay tax on dividends on shares in an ISA, or on dividends that are within your dividend allowance for the tax year.)

They also force you to make decisions with that money: do I spend it? Should I reinvest the money and buy more shares? Which shares? 

Because of this, I tend to just automatically invest in index funds. I’m investing for the longer term, and I’d rather the money stay invested so that it can grow and compound over decades. I’ll cash in the investments when I need the money, and deal with the taxes then, not every single year. 

But it’s impossible to avoid dividends altogether, because even certain index funds have them. Right now a fund that tracks the FTSE 100 will pay you around 5%. Depending on your circumstances, you should consider setting things up so that these dividends automatically re-invest. You’ll still pay taxes, but at least the money will stay in the market. And consider topping up your ISA first, since dividends are not taxed in ISAs.  

I tend to think of dividends like they are a small leak in my hot water tank. I’ve got a bucket under the tank, so I’m not losing the water, exactly (though some evaporates or spills – those are the taxes in this scenario). I can even take the bucket and pour it right back into the top of the water tank. But there’s no magic happening – no new water is entering the tank. There may be a time in life when I need that amount of water, so maybe – just maybe – that leak is helpful to me. But honestly, I’d be better off without the leak.  

When I want water, I’ll use the tap. 

Photo: Luis Tosta

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Written by E.A. Mann

E.A. Mann is a systems engineer and freelancer who specialises in finance writing. He is passionate about breaking down complex investing concepts so that everyone can understand them, not just the experts.

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