This post on why inflation dividend investing works in beating inflation was originally published by Sure Dividend. We were permitted to republish the post here.
Have you considered a lower risk strategy called dividend investing to beat inflation? It is often the simplest strategies which work the best over the long-run. Investing should be boring and allow to sleep soundly at night.
Dividend is a tried and tested strategy, but can it help you beat inflation?
What Is Dividend Investing?
The first part of dividend investing, consists of buying stocks which pay a regular and above average dividend. The second part of dividend investing, is to take dividends received and reinvest them to create even more income.
Dividends rely on cash earned to be paid out. Cash is king. Many firms have large revenues but do not produce much cash.
As a result companies which pay regular dividends are likely to have stronger financials underpinning them. This also means they are less risky.
Inflation, is the rise in the price of goods over the long-term. This means you overall wealth decreases as you have to spend more to get the same back as you would normally.
One way to protect yourself, is to invest into assets which over time grow you wealth. In this manner, your wealth can appreciate in times of low inflation, only for this increase to be dipped into to cover the costs of high inflation.
Why Dividend Investing Can Beat Inflation
Firstly if the company has strong financials you can rest assured you will receive a dividend.
This dividend yield is usually around 2/3% of the share price value, and goes a long way towards your negate the effects of inflation. (Inflation typically rises 2/3% a year).
Secondly, dividend investing is also about capital growth. Companies who grow their dividends year-on-year are rewarded with share price increases.
As a result, you get a combination of income + share price growth which will often outperform inflation increases.
Thirdly, Increased inflation usually means increased interest rates. Companies who can pass on cost increases are usually the staples, such as food companies and pharmaceuticals. These are the very sectors who pay the highest dividends.
Other Reasons Why Dividend Investing Works Well
Historically dividend stocks are less volatile which makes them less risky than other more growth focused stocks (which get severely punished if they produce a profit warning).
If you reinvest your dividends twice a year (most companies pay 1 small and 1 larger distribution per year) then you buy more shares which in turn produce more income.
Look our for companies which pay dividends quarterly as it means you can reinvest sooner, and grow your dividend income faster.
What you should focus on:
Search for companies which have a history of dividend increases of at least 10 years. This means they can weather an economic downturn. A company which has at least a 20 year history of increasing its dividend is often a ‘dividend hero’.
These will often be highly rated due to this history of success. A word of warning, if a dividend hero does cut its dividend (nothing is forever sadly) then its share price will be severely punished.
Another way of seeing how sustainable the dividend is, is a companies cash dividend pay out ratio. This measures as a percentage how much cash if left after all company running costs have been deducted.
A company which has a low % dividend pay out ratio is unlikely to keep paying its dividend.
Sadly we need to talk about tax. Income tax is traditionally higher than capital gains tax much to a dividend investor’s disappointment. As a result being aware that US and EU stocks have withholding tax is important within your dividend investing strategy.
EU stocks withholding tax can be particularly punitive. The US on the other hand does have the IRS (W-8Ben) form which reduces withholding tax for non-US citizens.
What Can You Invest In?
The UK’s FTSE100 stock market has traditionally always been a high dividend payer.
Typically this yield is around 4/5%. The European market, the Stoxx 50, pays a decent dividend yield of around 2/3% historically.
The USA is terrible at around 1/2%. This is due to US companies having a culture of using their cash for share buybacks rather than paying dividends.
For novice investors, it is best to focus on ETFs when starting their dividend investing journey. State street has an ETF called SSGA dividend aristocrats which has both a USA and EU focused version. These are famous for how well they have performed at producing income over the years.
The ubiquitous iShares brand has some dividend focused ETFs. Searching their website will bring up various dividend focused strategies for nearly all regions of the world.
In this way you can spread where your dividend is received from.
Risks To Dividend Investing
It can be risky to uniquely focus on dividends. You risk chasing yield, and some companies have artificially high yields. High dividend payers can be a sign of trouble – due to relationship between shares price and yield. This is known as the dividend yield trap.
Essentially a company which has poor prospects will see it’s share price drop, making it % dividend yield artificially high (sometimes as much as 10/15% dividend yield!). Companies like this are best avoided.
Be prepared for dividend cuts. These are often very painful as companies will wait until the last moment before cutting (making the share price punishment all the more extreme).
Indeed the problem is, you not only lose the yield but the shares will tend to sell off violently – often -10%/-20% on the day. You have lost both income and capital.
You should also be warned that some historic high paying stocks, such as the oil majors have a history of cutting dividends payments. This due to the oil price cycle, where a high price of oil causes a recession, which leads to a drop in demand. This means companies are unable to afford their dividends and therefore cut them.
Conclusion on Inflation Dividend Investing
Dividend investing is a tried and proven wealth creating strategy. Using it to beat inflation is intelligent but you should also measure your expectation.
High inflation cannot be beaten easily, all companies, even well-run professional ones will suffer.
Where you can beat inflation is by building up a consistent return of dividends over a period of years. This means that when high inflation does appear, the extra income you have created from reinvesting your dividends in the good years, will produce enough for you to keep living your life without too much worry from rising prices.
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This post was produced by Sure Dividend and syndicated by Wealthy Living.
Featured image credit: Shutterstock.
