Wednesday, 08 August 2012 - 20:00

 

Charts

Using Dividends as an Income Source

Many investors, particularly those that are approaching retirement, have an aversion to investing in the stock market. The reason most often used is that the stock market is “too risky for me”. While the daily and monthly gyrations in the markets make the average investor shudder, the opportunity cost of investing in cash and not having a growing income stream is too high for most investors. We have often said and written that the riskiest investment strategy over the long run is not to have enough risk in your portfolio.

In a simple exercise I have compared two investors that are 5 years from retirement (not taking tax into account. Taking tax into account would favour the investor who invests into shares). Investor A makes an investment into the ALSI (local stock market) and Investor B leaves his investment in cash. In both cases the investors let their savings grow with all distributions (dividends and interest income) reinvested for the first 5 years. From the 6th year both investors live off the distributions. The chart below shows the initial yield received by each investor (relative to their initial investment) in their first year of retirement.

It is clear from the chart that in most of the periods Investor A would be significantly better off in his first year of retirement than Investor B. The peaks in the dividend yield have coincided with strong market returns and strong dividend growth.

Investor A is further benefited by the fact that he’ll have a growing income stream once he moves into the drawdown phase, whereas Investor B’s income will be determined by the prevailing interest rates. Dividends are inflation proofed over time, with the chart below showing the annual growth in income (over rolling 5 year periods) of a cash investment versus an equity investment. An equity investor’s income would have grown, on average, at 13% per annum over this period, well above the average inflation rate. For those investors relying purely on interest income the picture is dire. Even before the effects of inflation there are many periods where a cash investor would need to reduce their standard of living. After taking into account tax and inflation the picture is even worse!

One of the reasons for the major discrepancy is that the market values of the shares grow above inflation over time, whereas the nominal cash investment never changes. By investing with this mindset, investors should be able to better weather those periods of poor market returns in the understanding that they are not going to be relying on the capital to provide an income, but rather the growing dividend stream.

At Seed we are aware of the importance of dividends in the total return generated by any portfolio, and as such our portfolios and funds currently have an allocation to higher yielding shares. This will not only provide a greater yield than the average equity investor (as depicted above) but has also traditionally provided more protection to investors in negative markets.

Take care,

Mike Browne

www.seedinvestments.co.za
info@seedinvestments.co.za
021 914 4966

Wed, 08 Aug 2012

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