Re-invest your dividends, make them work for you
This story originally appeared in The Sunday Times on Sept 30.
Published on Oct 2, 2012 7:39 PM
Much has been written in The Sunday Times Invest pages about investing for yields in these uncertain and inflationary times. Based on the performance of Reits and high dividend paying stocks like the telcos and utilities, it appears that local investors need no further convincing.
However, buying a stock for its high dividend payout is only half the story. To make an investment work as well as it ought to, a good investor must complete the other half of the story.
And that is re-investing the dividend.
Re-investing income from an investment, be it dividend, coupon, interest or rent, is a simple concept but it takes a strongly disciplined investor to abide by it.
Many ordinary investors tend to be lax about their investment income. If you don't believe me, ask yourself this question: How closely do you track the interests and dividends that you receive? Even if you do track them closely, what do you do with them?
For some, investment income is treated as bonus money to be spent. A friend, J, who has a rental property, tells me that she uses the rent she collects from her tenant to pay for her overseas vacation.
As she is a wage earner, she considers her rent money as extra spending money.
Don't get me wrong. I'm not saying that investors must live like a scrooge in order to maximise returns or that J is wrong to splash cash on an expensive holiday.
The point I want to make is that expenses should not be premised on the belief that investment income is spare money. It is not.
This is because the value of our principal is constantly being eroded by inflation. The dividend cheques that come our way are nominal returns, that is to say, they are not adjusted for inflation.
So if you spend all the returns, your financial position will be worse off than a year ago because inflation would have reduced your buying power.
Ideally, J should peg her annual holiday expenses to her annual wages to ensure that she does not spend more than she earns.
This may seem pedantic - after all, money is fungible, so does it matter that it comes out of the investment account instead of from one's salary?
But I will argue that the distinction is important, particularly if your expenses are perilously close to your earned income.
When expenses equal earned income, there is zero savings. And if you have to dip into your dividend income to fund further spending, you are whittling down your reserves even if the principal remains untouched.
That is why the Government is very careful in tapping the Net Investment Returns (NIR), which reflects income from the investments of Singapore's reserves, in a sustainable way.
Although computing the returns under the NIR framework is far more complex than my own simple illustration, the underlying principle remains the same, that is, preserving one's wealth is more than just maintaining the principal.
It bears reiterating that re-investing one's dividend is key to preserving wealth.
The other benefit of re-investing is to harness the power of compounding - which can be likened to a snowball rolling down a hill.
Compounding allows your investment to grow at a quicker pace as a result of the interest or dividend you earn not only on your principal but also on the accumulated interest and dividend payments.
Take a person earning an 8 per cent annual rate of return on $10,000 and putting his dividends in a savings account that pays a measly interest.
At the end of 20 years, his money will have grown to slightly more than $26,000. But if he had re-invested the dividends at the same 8 per cent rate of return, the value of his initial $10,000 will have more than quadrupled to $46,610.
If your investments are managed professionally as part of a pool - such as insurance products or unit trusts - dividend re-investment is not an issue as the fund manager has economies of scale in re-investing cash dividends in shares.
However, dividend re-investment is problematic if you own shares directly because so few companies on the Singapore Exchange offer scrip dividend as an alternative to cash dividend.
To be sure, one can always take the cash to buy shares in the market, similar to what a fund manager does. But it is not a good idea as the transaction costs for small share purchases are prohibitive.
It is no wonder that scrip dividend is popular with small investors as reflected by a participation rate of well over 80 per cent at OCBC Bank when this option was offered to shareholders.
It's a pity the bank suspended the scheme in its last two dividend issues, saying that it has adequate capital.
In today's liquidity-flush climate, profitable companies will find it cheaper to pay their dividends in cash rather than in new shares that will dilute future earnings.
This is a short-sighted approach. Shareholders who elect to take their dividends in scrip are usually in for the long haul. Surely, these are the kind of shareholders that companies want.
To make an investment work as well as it ought to, a good investor must complete the other half of the story. And that is re-investing the dividend.