E is for Equities

We’re now at the letter E and we hit another of the big beasts of the investment world, equities. Also known as stocks and shares. This is an important one so put down your phone and let me have your full attention. When you buy shares in a company you own equity in that company. Just like when your house is worth more than the mortgage on it. The difference is called equity.

Remember how with bonds we are lending a company money and getting paid interest on it? With shares, there’s no loan – we actually own a tiny fraction of the whole enterprise. It’s a very exciting and democratic concept – for a few pounds anyone can own a piece of some of the greatest companies in the world. It’s the basis of the capitalist system and the bedrock of your current or future wealth. I said there was no interest, but that doesn’t mean we can’t earn income from shares.

The bigger, more established companies pay out some of their profits as regular dividends to their shareholders if they don’t need to retain the money to fund their operations. Some of the best companies have a track record of gradually increasing their dividend payments over years and even decades. And here’s one of the most important investment nuggets you’ll ever learn. There’s hundreds of years of data to prove that most of your returns from the stock market will come from reinvesting these dividends into more shares. If you’re retired you can take the dividends as part of the income that you live on, but if you’re in the wealth accumulation phase you should definitely be reinvesting the dividends.

With interest rates on savings being so pathetic these last eight years, many people have turned to shares where they can receive three, four even five per cent a year dividends plus any capital growth if the share price goes up. The only problem is our old friend supply and demand. The more people chasing these dividend paying shares, the more expensive they get and the lower the dividend yield becomes as a percentage of the share price. So , as ever, try to buy when there’s a dip in the price for some reason. Better still, invest in a fund that offers a wide spread of dividend producing shares so you can spread your risks. There are many types of companies spread across lots of different sectors like technology, biotech, pharmaceuticals and so on.

Quite often technology companies will not pay much in the way of dividends as they focus on developing their products, but they can offer spectacular capital growth if their products are successful in the market place. For experienced investors, you might like to consider an approach called momentum investing, which focuses on companies already in a rapid growth phase and rides the upward wave to make big capital gains. But let me give a word of caution.

There’s a fine line between momentum and what I call bigger fool theory. In other words, if I buy this for a hundred pounds a share today I hope there’ll be a bigger fool willing to pay a hundred and twenty pounds for it in a few months time. We’re seeing a lot of this in the technology sector at the moment, with companies like Twitter on ridiculous valuations without troubling their accountants with any profits to bean count. Conventional wisdom has it that shares are riskier than bonds, which is why shares tend to offer a higher return.

You’ll often see asset allocations that suggest moving gradually out of equities and into bonds as you get older. I don’t buy it. Right now I see bonds as much riskier than the shares of quality companies. I also see a population living longer and needing reliable sources of income for several decades to come. I can’t give advice, but I assure you that even as I approach my sixties dividend producing shares in high quality companies feature much more strongly in my own portfolio than bonds in bankrupt governments.