Why do so few people invest money in shares? One of the main reasons, of course, is price fluctuations. Anyone who enters today will not know whether share prices might fall by ten percent or more in the course of the next year. But what many people forget: Equity returns do not only depend on prices. There is also the dividend income. This graph provides an overview of the long-term interaction between the two:
Past performance or future projections are not indicative of future performance.
An equity investor would look at the chart and see that the performance of the US stock index S&P 500 has indeed been quite volatile over the past eight decades. In the 1950s and 1990s, share prices rose by an average of approximately 14 percent per year, while in the 1930s they fell by an average of 5 percent per year. In contrast, dividends fluctuated only moderately. They always contributed between 2 and 6 percent to total annual earnings. This means that dividends cushion the price risk and reduce the overall risk of equity investments. This also applies to calmer stock market periods. There has not been a decade where the average overall loss was greater than 0.5 percent per year - not even after the turn of the millennium, when the dotcom and financial crisis shook the stock markets. Anyone who sees stock returns as what they are - dividends plus price gains - therefore needs to worry less about price turbulence.
I am often asked the same question in this context: whether one should therefore only bet on shares with high dividend yields. I advise against this. Equities with high dividends stabilise the portfolio, but ultimately the investor benefits from a good mix. They should rely on broad indices such as the S&P 500. This is because it also includes companies such as Amazon and Facebook, which have never distributed a share of the profits to investors, but have recorded strong price gains over many years.
We have considered the equity investor. Now to the financial market researcher. What do they see in the data? First, they recall a study by Robert Shiller, winner of the Nobel Prize for Economics. In 1981, he examined the extent to which the ups and downs of share prices are determined by their fundamental value, namely the dividends expected in the future. Result: share prices fluctuate far too much to be explained by dividend flows. The graph shows the phenomenon that researchers call the excess volatility puzzle: compared to price fluctuations, dividend payments change only moderately over time.
Then how can the high price fluctuations be explained? Behavioural Finance, a branch of research in economics and psychology, blames irrational investor behaviour for this phenomenon. Researchers argue that because investors are often driven by fear and greed, they drive prices up and down excessively.
Irrational behaviour may indeed contribute to the phenomenon. But there is also a rational reason: the dividend policy of many companies. Investors like to invest in shares with stable dividend yields, which seem comparable to the interest generated on a savings account and therefore are reasonably predictable. As a result, even if business is going badly, companies are trying to keep the dividend stable so that their shares remain attractive to investors.
The value of a share is ultimately determined by its long-term return on equity, i.e. the ratio of profit to equity. If a company pays a dividend, its equity capital is reduced. And if it makes losses, the return on equity is negative. This means that if a company keeps its payout constant despite incurring losses it pushes the return on equity even further into the red. As a result, the value of the share is falling more than would have been caused by the losses alone, creating additional turbulence. But that's not all: at the same time, the company's debt-to-equity ratio is also increasing. This continues to negatively impact the share price because it increases the risk of bankruptcy. Dividends might therefore be appreciated by investors, but they can be tricky for companies.
The same applies to bonus payments. They are great for employees, but also delicate for companies in a difficult situation. Because bonuses have the same effect on the return on equity as dividend payments. This can become a problem for companies that want to retain their employees in the long term through bonuses.
Risk Warning – With investment comes risk. The value of your investment can go down as well as up and you may get back less than you invest. Past performance or future projections are not indicative of future performance. We do not provide any investment, legal and/or tax advice. If this website contains information regarding capital markets, financial instruments and/or other topics relevant for investments of assets, the exclusive purpose of this information is to give general guidance on investment management services provided by members of our group. Please note our Risk Warning and the Website Terms.
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