Importance of dividends

Dividends matter more than some investors think. Growth-focused investors sometimes treat dividends as the icing on the cake, but they are more important than this. Here are six reasons why investors should care about dividends:

1. Re-investing dividends has a significant impact on the total returns from stock market investments. Thanks to the magical power of compound interest, dividends can make all the difference to even lack-lustre capital returns. Barclays Capital's 2009 Equity Gilt study showed that $100 invested in the US market in 1925 would have grown to $6,443 by the end of 2008 without re-investing dividends but to $193,687 if dividend income was re-invested throughout the period.

2. At a time of historically low interest rates, high-yield shares can make up for the poor returns on deposit accounts. A year or so ago it was easy to match the 5% yield offered by the MSCI Europe index in a risk-free savings account. Now the income from dividends looks comparatively attractive and the risk to capital of the equity investment is a more acceptable price to pay for the higher yield.

3. Focusing on high-yield stocks can improve your capital returns as well. At the market's lowest point in March 2003, the average share in the MSCI UK index yielded 4.8% while the 10 highest-yielding shares averaged 11.9%. As the market recovered from its lows, investors benefited not just from the higher initial income but also from the fact that the high-yielders gained 91% over the next year compared to the 49% achieved by the average share. Buying high-yielding shares can offer a "double whammy" - high income and a high capital gain as well.

4. In bull market in which the value of a share is rising at 15 or 20% a year, the addition of 2 or 3% in dividend income is nice to have but no more than a welcome addition to an investor's return. In a bear market, however, a high dividend yield can offset capital losses and act as a support to shares because the prospect of high and reliable income will bring in marginal buyers. As share prices fall, yields rise, making shares with a decent payout seem attractive compared to other income investments such as bonds.

5. Companies are generally unwilling to cut their dividend unless they really have to, although recent cuts have shown that there is less stigma attached to passing the payout than used to be the case. It reflects badly on a company's management and cuts tend to be punished in the market. For this reason dividends have tended to be less volatile than both earnings per share and share prices. Dividends smooth some of the ups and downs of investing in the stock market.

6. Steadily-growing dividends are an indication of the health of a company so it is not too surprising that companies that can boast a rising dividend payout have also tended to outperform the rest of the market. Rising dividends are a sign of strong cash-flow, which is the lifeblood of any company. Because of this dividends are not just for income investors.

Read - Earnings per share (EPS) ratio & what it means!

Investors beware of Brokerage and taxation!!!

You probably know the concept that all your transactions in the stock market are done though a "stockbroker". A stockbroker earns a commission on whatever transactions you make.

Suppose you make a transaction of Rs.2000, and the stockbroker charges you a 3% commission, then you have to pay the stockbroker Rs.60 (3% of Rs.2000) for the transaction. So your total investment in the transaction in “not Rs.2000”. The total investment in the transaction is Rs.2060/-

So after sometime, if the price of the stocks you invested in goes up to Rs.2060 then you have not made any money because the total amount you invested was Rs.2060/-

What is more, even when you sell the stocks, you have to pay the broker brokerage of 3%. This means that, when you sell the stocks for Rs.2060, you have to pay the broker Rs.61.6 so the profit of Rs.60 you made on the transaction is gone, in fact you actually make a loss of Rs.1.6!!

So in effect even though you made a profit of Rs.60 because your stock price went up, you have actually made a loss. If combine this with the fact that inflation reduces the value of money over time, you are just loosing money if you do not invest wisely without understanding brokerage and inflation.

Important note about brokerage: Brokers make money on whatever transaction you make. Whether you buy or sell, brokers will make money. Because brokers basically make money on transactions. Because of this, brokers tend to encourage you to trade. They don’t really care about whether you make a profit or loss. They just care about whether you are trading. The more money you are using for trading, the more they will make. Because of this, it would be wise to not blindly follow your brokers advise. The broker will give you “hot tips” etc. not because they are looking out for you and your profit, but because they are thinking about their own personal profit! There is even one more factor that eats into your money. Tax!!!

Please note: We are not in any way encouraging you to not pay tax! We are just educating you about it. There is a “short term capital gain tax” in our country. For a short term (less than one year) you have to pay tax on any capital gain you make though the stock market trading. How much % tax you have to pay, depends on which "tax bracket" you fall in.

Just to give you an idea. If I make Rs.100 though a transaction in the stock market, since I fall in the 33% tax bracket. It have to pay Rs.33 of that to the government!!

Please note: The government encourages you to be a long term-investor by having no long term capital gain tax. If you make a capital gain by investing for a period greater than one year, the you do not have to pay any tax on the money you make.

Now combine this short term capital gain tax with brokerage and inflation! Think about it for some time. You will almost make nothing on a small profit gains! If you want to make money out of the stock market, you must make large profit gains.

Conclusion: As a general rule, just for the sake of simplicity, your investments must grow at a minimum rate of 15% per year to stay ahead of inflation, tax and brokerage!! Remember this when making all your investments. This concludes our basics of the stock market guide. There is lot more to learn! And the best way to do it is to start investing! (Don’t invest too much in the beginning but do start!) Once you have your money in the market, you will start to understand things a whole lot better!

Best of luck! And Happy Investing... :)

Previous - Inflation and how it eats your money!

How "Inflation" eats your money silently!

Inflation, is an economic concept. What the cause of inflation is, is not important to us from the point of view of this article. What is important to us is the effect of inflation! The effect of inflation is the prices of everything going up over the years.

A movie ticket was for a few paise in my dad’s time. Now it is worth Rs.150. My dads first salary for the month was Rs.400 and over the years it has now become Rs.75,000. This is what inflation is, the price of everything goes up. Because the price goes up, the salaries go up.

If you really thing about it, inflation makes the worth of money reduce. What you could buy in my dad’s time for Rs.10, now a days you will not be able to buy for Rs.400 also. The worth of money has reduced! If this is still not clear consider this, when my father was a kid, he used to get 50paise pocket money. He used to use this money to go and watch a movie (At that time, even you could watch a movie for 50paise!)

Now, just for the sake of understanding assume that my dad decided in his childhood to save 50paise thinking, that one day when he becomes big, he will go for a movie. Many years pass. The year now is 2006. My dad goes to the theater and asks for a ticket. He offers the ticket-booth-guy at the theater 50paise and asks for a ticket. The ticket booth guy says, “I am sorry sir, the ticket is worth Rs.50. You will not be able to even buy a “paan” with the 50paise!!”

The moral of the story is that, the worth of the 50paise reduced dramatically. 50paise could buy a whole lot when my dad was a kid. Now, 50paise can buy nothing. This is inflation. This tells us two important things.

Firstly: Do not keep your money stagnant. If you just save money by putting it your safe it will loose value over time. If you have Rs.1000 in your safe today and you keep it there for 10years or so, it will be worth a lot less after 10 years. If you can buy something for Rs.1000 today, you will probably require Rs.1500 to buy it 10 years from now. So do not keep money locked up in your safe. Always invest money. If you can’t think where to invest your money, then put it in a bank. Let it grow by gaining interest. But whatever you do, do not just lock your money up in your safe and keep it stagnant. If you do this, you will be loosing money without even knowing it. The more money you keep stagnant the more money you will be loosing.

Secondly: When investing, you have to make sure that the rate of return on your investment is higher than the rate of inflation.

What is the rate of inflation?
As we said earlier, the prices of everything goes up over time and this phenomenon is called inflation. The question is: By how much do the prices go up? At what rate do the prices do up? The rate at which the prices of everything go up is called the "rate of inflation". For example, if the price of something is Rs.100 this year and next year the price becomes approximately Rs.104 then the rate of inflation is 4%. If the price of something is Rs.80 then after a year with a rate of inflation of 4% the price go up to (80 x 1.04) = 83.2

So, when you make an investment, make sure that your rate of return on the investment is higher than the rate of inflation in your country. In our county India, for the year 2005-2006 the rate of inflation was 4% (Which is really low and amazing!). This rate keeps changing every year. The finance minister generally gives the official statement on the inflation rate of the country for a particular year.

What is the rate of return?
The rate of return is how much you make on an investment. Suppose you invest Rs.100 in the market and over a year, you make Rs.120, then you rate of return is 20%.

If you invest Rs.100 in the market today and you make money at a 3% "rate of return" in one year you will have Rs.103. But now, since the rate of inflation is at 4%, an item costing Rs.100 today will cost Rs.104 a year from now. So what you can buy with today’s Rs.100, you will only be able to buy with Rs.104 a year from now.

But the Rs.100 that you invested has grown only at a 3% rate of return and so it is worth Rs.103. In effect, you are loosing money!

So in conclusion, the rate of return on your investments, have to be higher than the rate of inflation.

From the above paragraphs you can note how silently, inflation eats into your money. You would not even know about it an your money would sit loosing value for no fault of yours. But inflation is not the only thing you should be considering, there are other things too that eat into you money. The first thing is “brokerage” and the second thing is “taxation”.