Many New Zealand shares today offer excellent income streams of between 6.0% and 10%. Most provide the chance of growth in income over coming years. For people dependent on the income from their investments, shares can be a powerful ally.
Many folks desperate to earn higher levels of income are preferring term deposit look-alikes such as finance company debentures to shares. While finance company debentures are higher risk than term deposits (finance companies undertake higher risk lending overall than banks do and the risk of default is higher) they look and feel like term deposits. Shares on the other hand go up and down like yo-yos every day. There is also a perception in New Zealand that the sharemarket is a gambling den. Yes, shares are volatile, but there are ways of lessening this, which will be discussed later. As for the sharemarket being a ‘gambling den’, it can be, and many stubbornly treat it as such, but many more (probably wealthier!) people use it for the role it was designed for 300 years ago; to buy stakes in good companies which they hold on to for a long time.
Turning again to the volatility of share prices. Most people simply detest watching the value of their savings toss and turn and this volatility is probably a major barrier to many people investing in shares. There are ways to lessen volatility:
1) Don’t read the sharemarket table in the business section of the newspaper every day – this will prevent you making any rash decisions based on price changes;
2) take a long term view, volatility smooths out over time;
3) hold a good number of shares in your portfolio to provide safety in numbers;
4) buy companies that have lower risk businesses, like utility companies, as these tend to be less volatile than a small tech company for instance;
5) invest in shares that pay good dividends.
This begs the question, what is a “good” dividend. The best dividends are not necessarily the highest. When considering shares look for those that provide a reasonable dividend yield, but that also have the potential to grow this dividend. This dividend growth is arguably the crux of share investing. The ability to produce growth in income over time is what stands shares apart from all other investments.
Dividend growth comes from profit growth. Companies that are stagnant or shrinking may have a high dividend, but little or no dividend growth. This income growth is also important as a protection against periods when interest rates rise. Increasing interest rates usually cause share prices to weaken.
Firstly, investing for dividends reduces the risk of accounting fraud. As we have seen overseas, ill-meaning management can quite easily tamper with profit figures. Dividends provide a protection against such shenanigans. Because a company can’t pay a dividend unless it has cash in the bank to do so, dividends provide a measure of reassurance that the company does actually earn what it says it earns.
Secondly, shares that pay dividends tend to be less volatile because the dividend provides a sort of air-bag under the share price. If a share that provides a solid dividend stream suddenly falls sharply it often attracts buyers who buy in to capture the dividend yield, which will rise as the share price falls, i.e. the same dividend for a lower price. Once income investors become comfortable with the natural ups and downs of share prices and understand that the sharemarket doesn’t have to be the gambling den it is sometimes made out to be, dividend shares can be a very positive addition to your investment portfolio.