Dividends can pay off

Do I need to do that? Thanks to volatile investment markets, rising share prices are a lot less certain than they were. This has boosted the contribution of dividends to your total share returns. Many investors have become used to getting most of their return from shares from rising prices but, historically, dividends have played a bigger role.

The head of investment strategy for AMP Capital Investors, Shane Oliver, says more than half the 11.7 per cent annual return from Australian shares since 1900 has come from dividends (about 6 per cent a year). He says $100 invested in Australian shares in December 1980 would have grown to $874 by the end of August, based on capital growth, but $3213 once dividends are included and reinvested along the way.

The chief investment officer of ipac, Jeff Rogers, says dividends are also coming to the fore as baby boomers near retirement and start to think about investments that will provide money to live on. He says the Australian sharemarket is generating a dividend yield of close to 5 per cent, or more than 6 per cent grossed up to include the tax benefits of franking credits. However, those investors who specifically target yield could get a yield of about 7 per cent, or 8.5 per cent with franking credits.

That sounds OK but I'll still be behind if my shares fall by 10 per cent or 20 per cent. A strong yield won't stop you from losing money but it can cushion the impact. Oliver says research suggests higher dividends are also associated with higher returns over time. "Retained earnings are often wasted [while] high dividends reflect confidence about future earnings growth," he says. "Companies rarely raise dividends if they think it will be unsustainable. Only when earnings fell sharply in the early 1990s and around 2008-09 did dividend payments fall - but by much less [than the fall in earnings]."

Rogers says investing for income can also be a lower-risk strategy because it helps you to avoid the glamour stocks that crash and burn and to focus on companies that have good businesses and profits. He says if you are focused on generating an income, you should also be less fussed by short-term volatility than someone who is looking to sell their shares in a couple of years.

Is this a good time to be buying? Rogers says the yields are attractive and corporate balance sheets in pretty good shape, with many companies having recapitalised after the global financial crisis. He says most companies maintained or raised their dividends in the recent reporting season and this should continue.

But there are traps. He says the big one is to select companies with the highest reported dividend yields. He says a high yield may be on offer because the market believes the company's profits (or indeed its existence at all) is unsustainable. Yields can also be artificially inflated through means such as borrowing.

Rogers says buyers need to look forward and decide whether the company can sustain its earnings. Useful measures include examining its borrowing levels and its dividend payout ratio (the proportion of its profit that is used to fund dividends). If a company is paying out a high proportion of its profits, it is at more risk of having to cut dividends if profits come under pressure.

Rogers also advises that income investors should be wary of ending up too heavily concentrated in particular sectors. He says many of the best yields on offer are in retail stocks but focusing too much on this sector could leave you vulnerable to trends such as the rise of internet shopping. A global yield portfolio offers more diversification between sectors, he says.

Investors considering income-oriented exchange-traded funds should consider diversification, Rogers says, as some funds use a capital-weighted index and are more heavily concentrated in particular sectors or stocks.

While the current yields are not high, he says some investors could also consider including resource stocks for future income. He says dividends are currently low because most companies are investing heavily but there should come a time when they invest less and reap the rewards. He says BHP has indicated it wants to lift its dividends and many resource companies use buybacks to distribute franking credits.

* The author owns shares in BHP.