By Andrew Quinn

November 8, 2017 | News

TWD Investor Insights: Dividend Compounding

Investors commonly view market risk as existing in significantly higher or lower movements in the stock market. However, many investors underestimate the risk of a market going sideways for an extended period.

It’s common to show charts of the US S&P500 stock market index over a long period going ever higher. However, once inflation is taken out of the market chart the picture starts to look a little different. Remember that a long-term price chart of road gravel would also rise over time, given the effect of inflation.

When inflation is stripped away on a capital gain index like the S&P500, it becomes evident that long periods of volatile sideways movement occur. For instance, if an investor purchased the theoretical adjusted S&P500 below in the 1890s, he or she could have purchased the index at the same level in the 1950s, as shown in the chart below.

S&P500 – Inflation Adjusted

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More recently, even with inflation included, markets can move sideways for an extended period. For example, the Australian ASX200 index following the 2008 Global Financial Crisis. From late 2009 to 2016 the index effectively ranged sideways.

This presents a considerable risk for investors who (on a capital index gain basis) are exposing their funds to a market for little or no upside benefit, despite facing stock market downside risk.

Dividend Compounding

One method to potentially overcome “the risk of sideways” is for investors to concentrate on Dividend Compounding. This involves focusing a portfolio on a long-term basis towards sustainable higher yielding companies, and cycling dividends paid back into the same or alternative dividend-paying companies, thus compounding dividends through time.

The ASX200, through time, pays an average yield of approximately 4.5%. While tax considerations come into play when dividends are paid, by concentrating on higher yielding companies within the index, some of this tax effect can be negated. The ASX200 has components that pay no dividend or low dividends – thus tending to reduce the average yield across the index.

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The above chart shows the ASX200 index in dark blue, those investors who purchased the market near the top in 2007-2008 in the lead up to the Global Financial Crisis are yet to get their money back.

Those who acted to implement a dividend compounding strategy by cycling dividends back into the market, demonstrated by the grey ASX200 Accumulation line, have seen returns continue to move above the high prior to the Global Financial Crisis. The red line demonstrates the average yield across the ASX200 index.

TWD is well positioned to assist clients with Dividend Compounding strategies.

TWD is well positioned to assist clients implement long term dividend compounding strategies into their portfolios. The strategy is particularly suitable for superannuation and long term hold portfolios such as those set up for children and grandchildren.

Disclosure: Past performance is not necessarily indicative of future results.

Words by Andrew Quinn.