FOOL'S EYE VIEW
Shares Pay Dividends In Retirement

By Jane Mack (TMFJane)
September 27, 2002

Last night two of our favourite people stayed over with us. They're amongst my favourite people because I can have a jolly good argument with the husband without him taking offence – usually he just laughs at me (and my sweeping statements) – but he makes me think a bit. Hopefully I manage to return the favour occasionally.

Anyway, last night we were arguing about the stock market. He couldn't understand why people invested in the stock market. According to him, everyone seemed to be panicking about it so it was obviously a Really Bad Place to put your money.

So, I told him about how, since 1869, investment in the stock market, in real terms, had grown by 6.4% per year compared to the pitiful returns from cash (1.8%) or gilts (1.7%). Yada, Yada, Yada. I also pointed out to him that if you invest in the stock market, you have to live with the occasional investor panic. You will get them from time to time, but no one knows when. Hence the need to take a long-term view. Obviously no-one lives for nigh on 150 years but you get the point - short-term ain't long enough!

And then I started talking about dividends as a form of income. My husband and I are thinking – just thinking – about the idea of buying a house in France in the next few years as part of our future retirement plans. So is my argumentative friend. He wanted to know how we might manage to fund ourselves in our old age – in a foreign country.

So, I started explaining that one way we could use our assets to generate an income would be to invest a proportion of our money in 'high yield' shares so that we could live partly off the dividend income.

So, he said, how do dividends work?

Well, I said, if I buy £100,000 worth of shares in a company at £1 each, the company would pay me a proportion of their profits. Perhaps if I chose the right company, I'd get a return on my investment of, say, 5p per share – ie: £5,000 a year in income.

So, he said, if your £100,000 worth of shares rose in value to £200,000, you'd get double in dividend payments?

No, I said. Assuming the dividend is still 5p per share, I'd still only get £5,000 per year because I've only got 100,000 shares. However, my investment of capital would have doubled. If I sold all the shares to realise the capital, it's true I'd get twice my initial investment back – but then I'd have to find somewhere else to invest that money. If I kept them, at least I'd get what I was after in the first place – a return of 5p for each of my shares.

What about if your 100,000 shares dropped in value to £50,000? He said.

Well, obviously, I said, so long as the company is still paying the same 5p per share dividend then I'd still be getting my £5,000 per year income. After all, I'd still have 100,000 shares - regardless of what they'd be worth if I sold them on the open market.

So, he said - at their peak - why on earth would anyone buy 100,000 shares for £200,000 if they could get them for £50,000 by waiting until they dropped in value?

Well, I said, that's the thing about investing in the stock market. You wouldn't know that they were about to do that. The idea is that you buy companies that produce dividend income - in this case 5p per share. But, over time, investors change their minds about how much that income is worth. Perhaps they start to wonder whether that the 5p dividend per share will go up or down or they might even think a 5p return isn't enough considering how much they've invested (which might happen if inflation and interest rates change).

You have to take the highs with the lows, but usually you can at least rely on the dividend income to remain steady because companies don't like to chop and change it too much. Shareholders generally like a steadily growing stream of income, so that's what the companies try to serve up. If all you're really interested in is the dividend income, then who cares about the capital?

But surely people would prefer to buy 100,000 shares at £50,000 instead of £200,000 - particularly if they're all going to get the same dividend income anyway? He said.

Exactly, I said. That's why people dip in and out of the market all the time. It's why people panic all the time. They're worried about their capital investment. It's why they lose money. Because every time they buy or sell they have to pay for it – through expensive brokers' fees or because they make mistakes by buying when the share price is too high or selling when it's low. Too much changing your mind about capital values ends up being expensive. You need to remember what the shares are actually for in the first place -- which is to produce a gently rising dividend income.

Oh, he said. I didn't realise it was as simple as that.

It is, I said... sort of...

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