Investors in Singapore love dividends. I see it all the time: a fund pays out, so people buy it. A fund does not pay out, so they will not look at it.
I understand the appeal. Money arriving in your account every month feels like proof that the investment is working. Dividend funds have a place, and I use them for clients too. But choosing a fund mainly for its payout can cost you, for three reasons.
1. The payout can come from your own capital
A fund’s payout and its return are two separate numbers. If a fund grows 5% in a year and pays out 7%, the extra 2% has to come from somewhere, and that somewhere is your capital.
In a bad year it gets worse. If the fund falls 10% and still pays out 7%, you end the year with around $83 for every $100 you started with. The fund then has to grow about 20% just to get back to where you began.
I have seen investors in funds paying around 7% a year check their capital after ten years and find it at about 60% of what they put in. They were shocked. They had thought of the 7% as extra money.
Paying a high dividend with no growth behind it is like taking money out of someone’s wallet, handing it back, and saying, “See, I gave you money.”
So look at total return, meaning the payout and the change in capital together. When I choose dividend funds for clients, I prefer ones that pay from what the fund earns, with a clear source of growth behind the payout.
2. The payout may not suit the fund’s strategy
Regular payouts suit large, established companies that are no longer growing much and return their profits to shareholders. Smaller and mid-sized companies tend to keep most of their profits to fund their growth, so they pay little in dividends. A fund built on them earns little income of its own. If it still promises a high regular payout, it has to sell some of its holdings to pay it, including in bad years when prices are low. A long-term growth strategy needs the opposite: time, and holdings left alone to grow.
Some fund managers have told me that they have to market certain funds as dividend-paying, because many retail investors will not consider a fund without a payout. When a fund has to keep up a high payout through its early, volatile years, the strategy may never get the time it needs. Investors see their capital shrink and walk away thinking unit trusts do not work, when the real problem was a payout the fund’s holdings could not support.
3. You may not need the payout yet
The question I keep coming back to is what the money is for.
If you are in your 40s and working, your salary pays the bills. You are investing for later, most often retirement. Compounding only works when the returns stay invested and earn returns of their own. Take them out every year and your growth is, at best, a straight line.
For illustration, assume $100,000 earns 6% a year, which is not guaranteed and is before fees. Left to compound, it grows to about $179,000 in 10 years and about $321,000 in 20. If you take the 6% out each year instead, you still have $100,000 after 20 years, plus $120,000 in payouts along the way. That is about $100,000 less, and the gap keeps widening the longer you invest.
There is also a practical problem. On $10,000 paying 5% a year, the monthly payout is about $42. Many people tell me they will reinvest it themselves. In practice, small amounts like that tend to sit in the bank.
Someone once told me he was investing for his children’s university fees, 15 years away, in funds that pay monthly dividends. Small payouts were arriving now, when he did not need them, while the money was not growing as well as it could towards the one goal it was for. The risk is that he reaches the year the fees are due and comes up short.
I have written more about funding a child’s education in Your Child’s Education Should Not Cost You Your Retirement.
When dividends make sense
If you are retired and need income, a dividend fund can be a good fit, as long as you have checked that the payout can be sustained by what the fund earns. This matters most in the first years of retirement, when a bad market and steady withdrawals together can do lasting damage. I explain why in The Millionaire With Four Years of Retirement Money. Some people have other specific reasons to want regular income, and that is fine too. It is less common than you might think.
If you do not need the income yet, consider a fund that reinvests its returns. Many dividend funds also offer an option to reinvest the payouts automatically, which lets compounding do its work without you having to remember.
Start with what the money is for, and choose the fund to match. Like the cash in your bank, your investments work best when every part of them is intentional.
