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As dividends roll in, sitting tight may be best strategy

Mark Arndell is investment centre manager with Danske Bank

Dividends paid by UK companies were at a record high of £27.2bn in the third quarter of this year, according to the quarterly 'UK Dividend Monitor' published by Capita Asset Services.

Financial company dividends have grown the fastest, rising by 44.4%, due mainly to Lloyds Banking Group's first interim dividend since the financial crisis. The pound was lower against the US dollar, and because half of the top 20 dividend payers declare dividends in dollars, this boosted returns in the third quarter by £600m.

Against these trends, consumer services were sharply lower as supermarkets continued their price war, reducing payouts and, in the case of Tesco, cancelling the dividend payment altogether. Full year dividends were, as expected, £87.2bn in 2015, a 10% drop from 2014. While the UK economy continues to perform strongly, dividend forecasts for 2016 have been revised downward, as slower global growth will eventually have a negative impact on UK companies. The outlook is also clouded by lower dividend cover (a measure that considers dividends paid relative to the value of a company's profits) partly due to the importance of oil and mining companies listed in the UK. Falls in commodity prices have meant that dividend cuts are likely in this sector.

The desire for yield is a powerful motivator in a world of near zero interest rates. Even with the predicted decline in dividend payments next year, UK equity yields are expected to rise to 4.1% over the next 12 months, remaining the highest yielding of the major asset classes. Capita quotes UK government bond yields at 1.8% for 10 years and property at 3.6% (net of costs).

Dividends not only provide income but, if reinvested, they are a major contributor to total investment returns. They account for about half of all returns from investing in shares. Strong dividends therefore should be an integral part of maximising your overall returns. Continually reinvesting dividends and allowing the magic of compound interest to work will bring significant benefits to your investment returns.

Albert Einstein is often credited with saying: "Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn't, pays it."

So, even with recent market volatility, a good investment strategy could be to sit tight and let those dividends roll in. This effectively means buying cheaper shares in the troughs and fewer expensive shares at the peaks. Market volatility is likely to continue, at least in the short term, as Chinese manufacturing data for October came in below expectations. It has shown signs of bottoming and expectations are for improvement in the coming months, which should boost emerging market assets and risk assets in general. However, any lift to sentiment may be tempered by the fact that an improvement in China raises prospects of a rate hike from the US Federal Reserve in December, with odds of an increase currently at 50%.

Jeremy Stewart returns next week

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