by John Jagerson, Analyst at
Learning Markets
Stock pickers have to be able to show a big return in a short period of time in order to capture your attention and to sell their services. This creates an incentive for these kinds of analysts, advisers and writers to make big bets. A big bet in the stock market could make the stock picker a legend or a goat but the real issue is that its tough to tell the difference before the fact.
This phenomenon is one of the factors that has turned many investors into little more than participants in a huge ponzi scheme. Investing in the "growth" oriented stocks these stock pickers recommend may seem attractive but what they promise in future returns often comes with the significant sacrifice of cash flow back to you the shareholder.
At some point over the last few decades, academics, management and financial theorists have convinced many retail traders that a stock's value is not a function of expected future payments (dividends). But if there are no payments/cash flow from a stock then its value must come from the anticipation of increased demand for the shares from future investors.
If we follow this logic then we would have to assume that if demand from future investors was static or declined then it would be impossible to derive any value from the investment at all. Therefore, cash flow from a stock seems to be as important if not more important than a company's growth potential.
Although corporate management clearly benefits from the lack of demand for dividends as there is more cash available for compensation not all companies are managed this way. Dividends should matter to stock investors, they are available and they can make the difference between a profitable long term portfolio and one that is not.
Depending on how you do the math, 40-60% of total stock market returns over the long term are actually due to dividends not price growth. Because dividends (not P/E ratios, sales growth or new product introductions) are directly responsible for half of the stock market's total returns it seems logical that individual investors should educate themselves on how dividends work and how their benefits can be maximized.
In the video accompanying today's article I will cover a few examples of how dividends made the difference between winning and losing as a stock investor over the last 10 years. In addition to understanding the benefits of dividends there are a few tips for making the most of these payments that we will be expanding on in the next article.
Compounding is key:
Dividends are great but they are even better when you can reinvest these payments into the market. This increases your holdings, which in turn earns more payments on a larger pool of stock. Over time this compounding makes the difference.
Indexing to reduce risk:
Just as there are stock pickers, there are dividend pickers. However, these analysts are often just return chasing. Its not that individual dividend paying-stocks are bad, it is that they are more risky than a pool of stocks that pay dividends. Sticking with indexed ETFs and funds that focus on dividend paying stocks will reduce exposure to the risks around a single stock.
Taxes and costs:
Dividends and gains of all kinds in the stock market have tax consequences, which can reduce profits. Similarly, reinvesting in the stock market leads to increased transaction costs. There are ways to maximize your accounts and strategies to minimize these issues.
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