Beginners guide to investing part 11:How do shares make (and lose) money?

“One of the funny things about the stock market is that every time one person buys, another sells, and both think they are astute

— William Feather

INTRODUCTION

A common misunderstanding of the stock market is that it is gambling. Stocks are only gambling if our method of investing is one of high risk and trying to predict the market. The stock market is not the place for gambling for the common investor. If you want to gamble, go to the casino. You’ll have better luck.

It is extremely tempting to try and get rich quick, but more often than not, that will get us poor quick. Then we will find ourselves in a position of being too scared of ever wanting to invest in the stock market again. This would be a shame. The stock market is one of the best methods to grow our wealth.

In 2008 we experienced the global recession. For the NZX50 stock market that meant a 33% drop in value. A $100,000 investment would have been reduced to $66,000 in less than one year. This drop was enough to see many people exit the share market. I know of a few. Some of them have only just re-entered the share market recently after being scared off for the last 9 years because of what happened to them. They have been sitting on the sidelines for 9 years, whilst the market has increased in value by over double. 13% per year. If my friends had stayed in the market, their $66,000 would now be $132,000 if they never invested another cent. Much more than $132,000 if they continued to buy monthly shares using dollar cost averaging. They missed out on buying cheap shares in 2008 at the bottom of the market. Because the impact of the recession happened so quick, my friends sold their shares when they were quite low in value, and now they have some confidence back in the market, they are buying when shares seem a bit expensive. They seem to buying high and selling low. The worst thing an investor can do. If the market were to drop again soon, that may be enough to discourage them investing in the stock market for the rest of their life. The market to them will seem unforgiving.

Take someone that started investing in 2009 though. Although both investors are in the 2017 market, the investor that came in in 2009, after the crash, will be very confident about the market. They have experienced returns of 100% over that period. They have never experienced a crash. There was a small correction of minus 1% in 2011, but nothing major. The 2009 investor may even start to think that this 8-year run will carry on forever and start investing more aggressively. Greed may take over, until they get scared off when the next crash happens.

In the two examples provided, you can see how easy it is for two people in the SAME market to have such DIFFERENT views of the market. This is what is known as behavioural investing. Decisions made on emotions, rather than basic fundamentals such as company performance.

 

HOW DO SHARES MAKE MONEY?

As a stock investor you are part owner of a business, and there are two ways for you to make money:

  • Increase in price
  • Dividends

 

1/. Increase in price
The stock price can go up or down and this is based on how much someone else is willing to pay for our stock. If the stock has gone up in value, it generally means that people believe this company is worth purchasing at the current price. As more people purchase stocks in the company, the price keeps pushing up.

There are a few reasons someone may purchase a stock:

  • They obviously believe it is going to continue to go up in price
  • They believe the company is performing well
  • They believe in the company’s product or service offering
  • They have confidence in the company’s board members and directors
  • They are in a passive managed index fund that automatically purchases a piece of each company
  • They believe the company is undervalued and has great potential
  • Their friend told them too
  • They like the company name

Some reasons for purchasing stocks are a result of analysis and research. Other reasons are a bit more emotional, such as they like the company name, or their friend made the suggestion. It is these emotional investors that make it difficult to predict what the market is going to do on a given day. How can we predict irrationality? Anyone who says they can is one of the irrational ones!

The change in price of the stock is not realised until we sell though. So, don’t go thinking you have made money if you still hold the stocks. You haven’t made money until you sell. 

One thing to note about passively managed index funds. With the proliferation of this low-cost alternative, more investors are committing to this form of investing due to low cost, highly diversified model. Due to the increasing popularity of index funds we may be more likely to experience wild swings in the market. The reason is more people investing in more companies, means when there is a decrease in value of the index fund, there is a decrease in value of ALL stocks. Before index funds, if there was a crash, people may have still been able to find a few good companies to invest in, such as consumer staples. However, index fund investors either have to invest in all or nothing. And in a crash, many will invest in nothing. In good times, they invest in everything. This should result in higher highs and lower lows.

 

2/. Dividends
A dividend is a payment to the shareholder (you), taken from the earnings of the company you are invested in. Not all companies pay dividends though. Especially companies that are starting out or expanding. They need all their earnings to be re-invested into the business for growth. Growth business should ideally see a larger increase in their share price than dividend paying companies though.

Companies that do pay dividends often payout twice a year, and it is a percentage of the company earnings. The highest dividend companies are often well-established companies with not as much reinvestment for further growth. Generally, high dividend paying companies have lower share price increases due to their lower potential for growth. Energy companies historically pay good dividends.

Overseas investors are drawn to NZ shares because of the high dividend yields, relative to their home country. Approximately 50% of investors in the NZ share market are from outside NZ. Dividend investing is popular among retirees and anyone looking for regular sources of income. The key to looking for good dividends is a track record of paying dividends and increasing the dividend amount each year.

Remember that dividends are only one part of the share returns. Increase in price is also important. If a high dividend company experiences a decrease in investors, then their price will likely go down. This will mean less investors lending their money to the company, which will mean less money for the company to operate and grow. Dividends may then decrease. So, just because a company is a good dividend paying company now, it is important that they still have good business fundamentals to ensure future dividend payments.

There is also a common misconception with dividends worth mentioning. When a company pays a dividend, the company value/stock price decreases by the amount of the dividend. For example, a $5 share that pays out a 25 cent dividend per share to its investors, will now have a share price of $4.75 all other things being equal. Sometimes the share price goes up after a dividend is paid which confuses some people. They think the dividend paid does not decrease the share price. But in this situation, the share price would have increased for other reasons totally unrelated to the dividend, such as investor confidence. In fact, it would have increased by 25 cents more if a dividend hadn't been paid out. 

There is also a third way that share investing can make us money, by saving money……

 

3/. Tax benefits

International
There are some tax benefits of investing in shares worth mentioning that also help with our returns.  In New Zealand, we generally only have to pay tax on dividend income, not capital gains. Unless we are seen to being a trader trying to make a quick buck. The key distinction is whether we are seen by the tax department as an investor or a trader.

Overseas investors (excluding Australasia) are hit with extra tax payments of 5% of our portfolio if our opening balance is over $50,000. John for example has offshore shares worth $100,000 at the beginning of the year. During the year he earns a return of $10,000 and dividends of $10,000, making his total return for the year $20,000. However, his taxable income is limited to 5% of the opening balance ($100,000). This results in taxable income of $5,000. Under the fair dividend exemption, the dividend income of $10,000 is not taxed, unless it is less than 5% of the opening balance. If we hold less than $50,000 we are exempt from the overseas buyers’ tax. We just have to pay the standard tax on dividend income (not capital gains).  

The 5% tax is added to our taxable income from all other sources, which is then taxed. So, if we are in the top tax bracket of 33%, we will pay an extra 1.65% in tax. In other words, 33% of 5%. We are generally not taxed on dividends if our portfolio loses money. It can get complicated, so advice from a good accountant will come in handy here.

Local
If we are in a NZ managed fund, then we will only have to pay our prescribed investor rate (PIR), which is a maximum of 28%, on all our dividend income.  But, most companies reduce this payment, so the shareholders don’t have to pay this tax. These are known as imputation credits and are a great benefit of owning shares.

Basically, because companies have already paid tax on their earnings, some of them give their investors imputation credits so that the investor doesn’t need to pay tax as well. It saves the same income being taxed twice. The company pays it, and the investor receives most of it tax free. Now this is a very basic, dumbed down version. The most a company can legally impute is 28%. If our income tax rate is 28%, we will not be required to pay any income tax on our earnings. If we are in the 33% tax bracket, then we will need to pay just a further 5 cents per $1 of gross income. 5% tax. This is much better than tax paid on bond returns and bank savings. There are some companies that don’t pass on the full 28% imputation credits, or any at all for various reasons.  So, if our income tax rate is higher than the imputation credits, we would be required to pay the difference in NZ income tax. Imputation credits earned from overseas investments are not for valid use in New Zealand.

If we are invested in high dividend companies, it can be worth checking if they fully impute their credits or not. It can make a difference over time, especially if we receive a substantial amount of dividends. This strategy would not work though if dividends make up a large proportion of your total income. For example, say we are in the 17.5% tax bracket and receive a dividend of $100. We would pay $17.50 of tax. BUT, the company fully imputes our dividends at 28%. This means we get tax credit of $28 that has already been paid by the company. The good news is we would pay no tax. $28 credit is more than $17.50. The bad news is we have left $10.50 in excess that we would have been entitled to if you were in a higher tax bracket.  In current legislation, we can’t claim this back as a refund. This should definitely not be a major criteria in deciding where to invest, but should be considered nonetheless.

I personally don’t believe that tax is a main reason for buying or not buying a certain investment, but if you are 50/50 on deciding, it may well be the deciding factor.

 

FINAL THOUGHTS

There are a few ways that shares can make an investor money. Most companies worth investing in are either high growth or high value. It would be very rare to find both. Growth companies generally make us money by their share price increasing. Value companies generally make us money through high dividends, with hopefully some share price growth too. Depending on our investment strategy and risk levels, we can invest accordingly to match. Do we want cash in the hand now, or would we rather higher capital gains?

The tax benefits of investing in shares are quite attractive to investors too. It means the income earned we get to keep, instead of paying up to a third of it to the government, like you would with some other forms of investments.

If we are comparing the change in value of the New Zealand share market against international markets, just be weary that the New Zealand market includes dividends in their total returns. This is known as a gross index. Most other markets internationally only include the share price movements, and not the dividends. Known as a capital index. Yes, international markets tend to have lower dividend payments, but it is still not a fair comparison. The gross index reporting was most likely introduced to make the market appear more attractive to investors than it may have looked as a capital index. This shows that dividends are a big part of the New Zealand share market scene, with a lot of well established companies. The question is, can they continue to grow and where will the next wave of new company growth come from?

Next time,we will discuss the difference between average returns and real returns and how the distinction can make a difference to your investing.

 

 

The information contained on this site is the opinion of the individual author(s) based on their personal opinions, observation, research, and years of experience. The information offered by this website is general education only and is not meant to be taken as individualised financial advice, legal advice, tax advice, or any other kind of advice. You can read more of my disclaimer here

 

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