February 3, 201
Conservative investing in dividend-paying companies will soften the blow of negative returns
Fund managers know and understand the benefits of capital preservation. They know negative returns are best avoided because of how difficult it can be to just get back to square one.
But ordinary investors probably don't appreciate the maths and the sort of high returns required to recover from losses. For example, a loss of 10 per cent requires a return of 11.1 per cent to get back to square one. A 20 per cent loss requires a return of 25 per cent and a 70 per cent loss requires a return of 233 per cent.
So big losses are likely to take a long time to recoup, which is why investing with an eye to avoiding losses in the first place is so important in growing an investment portfolio.
- That is particularly pertinent to the sharemarket because shares quite regularly lose 5 per cent or 10 per cent of their value and, occasionally, much more.
- From the bull market peak of November 2007 to the bear market trough of March 2009, Australian share prices fell by more than 50 per cent.
- While the Australian sharemarket has risen by about 45 per cent from the trough, it remains more than 30 per cent off its all-time high of November 2007.
However, the mathematics of capital losses say that for Australian share prices to return to record levels, share prices need to rise by almost 50 per cent from here. And that could take years, says the head of investment market research at fund manager Perpetual, Matthew Sherwood.
Sherwood cautions investors who, tempted by the easy gains, are considering throwing caution to the wind and going headlong into the sharemarket hoping to quickly recover earlier losses.
He says most of the easy gains on the back of the economic recovery have probably already been made.
"The best thing to do is to invest conservatively and reduce the risk in what is going to continue to be a volatile environment," Sherwood says.
Investing conservatively means selecting good, dividend-paying companies. A portfolio of income-paying shares helps take some of the sting out of the tail of the capital losses, he says. As economic conditions improve, so do dividends.
Fund managers tend to favour companies that pay consistently high dividends because of the fact that it helps smooth out the volatility of share prices for the investors in their funds.
Even when a company's share price is falling, it usually keeps paying dividends to investors. "Since 1882 the Australian sharemarket, on average, has returned about 12 per cent a year and half of that has come from dividends," Sherwood says.
The importance of dividends to Australian investors is not only that more of the total return from Australian shares is made up of dividends than is the case with overseas shares but that the dividends are favourably taxed in the hands of investors through our dividend imputation system.
The point for investors is simple. The best way for investors to get ahead is by having a well-diversified portfolio of consistently performing investments. That is likely to be a much more profitable route for investors in the long-term than holding a portfolio of investments whose returns are highly volatile and do not pay much by way of dividends.
Successful fund managers, such as Perpetual and Investors Mutual, have an investment philosophy that focuses on capital preservation and on investing in income-paying investments with the aim of delivering consistent total returns of regular income and capital growth.
Such an approach means the fund manager is unlikely to appear at the very top of performance league tables in any year but instead will provide the unit holders in their share funds with higher returns in the long run. Individual investors would do well to follow their lead.
The smoother ride provided by a lower-returning, income-paying investment will also help ensure investors stay invested.
Faced with significant losses, investors are more likely to take fright, sell their shares and put their money into cash, which in the long-term is the lowest-returning asset class of all.
Sticking with a portfolio that produces consistent returns has another advantage in that investors do not feel pressured to seek out the next big thing in the hope of making spectacular returns.
Trading not only takes up much more time, "churning" a portfolio also increases both transactions costs and taxes, particularly if the share is held for less than a year.
What you need to make to recover your losses Cost Loss Price Return price (%) After required (%) loss (%) $100 5 95 5.3 $100 10 90 11.1 $100 20 80 25 $100 50 50 100 $100 70 30 233 $100 90 10 900 SOURCE: FAIRFAX