I WAS in a thoroughly bad mood yesterday. Preparing my tax return, I totted up the value of my share portfolio and couldn't help but make the dismal comparison with last year's valuation. As investors, we are obsessed with share prices. News items focus on movements in the prices of individual companies and capital indices such as the FTSE 100.
Amid the current commotion, it is easy to forget that investment returns actually derive from two components, namely share price appreciation (or depreciation) and dividends.
If, yesterday, I had looked more closely at the dividend income my port
folio has been generating, I'd have been cheered to see that it has actually grown over the past year.
Jack Bogle, founder of US fund management group Vanguard, once said that "the stock market is a giant distraction from the business of investing". This may sound paradoxical, but how right he is.
Obviously, it is difficult to avoid being influenced by the equity markets' recent falls. But there are a number of reasons why we should ignore the oscillations of the market and concentrate instead on the dividends paid by the companies in our portfolios.
Certainly, share prices can be accurate indicators of the financial health of companies, but they can also reflect speculation and history shows that share prices are far more volatile than the underlying businesses.
For investors, this excess volatility can be distracting and unhelpful. Equity investing is about buying part-ownership of businesses, and sharing in their profits. A dividend reflects the decision by a company to pay out part of its profits to owners.
For owners of a diversified portfolio, profits are more stable than share prices, and dividends even more stable than profits.
We also forget, as I did yesterday, that share prices are only relevant when we buy or sell. And even if we are buying or selling, concentrating on dividends can help investors avoid a common behavioural trap. When markets are falling, we tend to get more pessimistic and likely to sell – at consequently low prices.
If we focus instead on the dividend income of shares (the amount paid out in dividends for every £1 of shares bought), we are more likely to overcome this instinctive trait.
Recent share price falls, together with steady dividend payments, mean that every £1 investment in shares buys more dividend income today than a year ago.
Of course, dividend streams are not infallible. Dividends largely reflect corporate profitability, and profitability depends on the economic environment.
With growth slowing and inflation rising, corporate profits are likely to be squeezed and this is likely to feed through to a slowdown in dividend growth and, in some cases, even dividend cuts.
We are starting to see this: a few companies have announced dividend cuts, some banks hid dividend cuts among their recent rights issues, while yields of many income funds are under pressure. But any reasonably diversified portfolio will always show operating profits; and where there are profits, investors should continue to collect dividend cheques. Moreover, over the long-term, the dividend income of such a portfolio should grow steadily.
Certainly, dividend income on UK equities has risen over the years. The graph opposite – courtesy of the Barclays Capital Equity Gilt Study 2008 – shows that if an investment in the FTSE All-Share index paid out dividend income of £1 in 1967, some 40 years later the same investment was generating £19 in annual dividends. It is also notable how stable dividend income has been, particularly compared to any graph of share prices over the same period.
Most investors underestimate the long-term contribution of dividends to investment returns. Research by Dimson, Marsh and Staunton of the London Business School (LBS) showed that between 1900 and 2007 the total return on UK equities was 9.7 per cent a year, of which only 4.8 per cent – was attributable to capital appreciation. Dividend income accounted for the remaining half.
The LBS team found that, unsurprisingly, over single-year periods, investment return was dominated by share price gains or losses, and the contribution of dividend income to returns was slight.
But over the longer term, the picture changes considerably. The contribution to total return from dividends becomes increasingly significant, particularly if dividends are reinvested, thanks to the magic of compounding.
An investment of £1 in UK equities in 1900 was worth £164 by 2007. But if, over the years, dividends had been reinvested rather than spent, the same investment would be worth a staggering £22,252. This remarkable phenomenon can be seen in markets around the world.
It is perhaps no wonder that the American industrialist John D Rockefeller said: "Do you know the only thing that gives me pleasure? It's to see my dividends coming in." Few investors have wealth on Rockefeller's scale, and many of us need to spend our dividend income, particularly in the current financial climate. But whether they are spent or re- invested, dividends do matter.
With prospects for capital growth in equities looking uncertain, do not to underestimate the importance of dividends over the long term. Just don't let the current markets distract you from the business of investing.
The full article contains 871 words and appears in The Scotsman newspaper.
