Investments should result not only in capital appreciation but also stable cash flows
The stock market tanked in March and yet again on the last day of August. While the crash in March was attributed to the outbreak of COVID-19, the political tension with our neighbour was cited as the reason for the fall in August.
An investment portfolio is vulnerable to political uncertainty, natural calamity and financial crises. In this article, we discuss how you can moderate the effect of such factors on your portfolio.
All of us typically invest in equity and bonds. Equity investments could be directly in stocks or through mutual funds and bond exposure would be typically in bank fixed or recurring deposits (FDs and RDs).
Both bonds and equity offer two sources of returns. You can earn dividends and capital appreciation from equity, and interest income and capital appreciation from bonds. Now, investing in FDs means giving up capital appreciation on bond investment. However, you enjoy the certainty of cash flows on deposits as compensation for giving up capital appreciation.
Suppose you want to buy a house six years hence, you can invest in a cumulative FD maturing in six years. You know today the cash flow you will receive six years later. Or, you can invest every month through RDs and still enjoy certainty in cash flows. An investment in a bond fund may generate capital appreciation but you would not know today the cash flows you will receive when you redeem units six years hence. Same is the case with equity investments. That causes anxiety when the market tanks. So, what should you do to reduce emotional stress?
Your equity investments should earn returns from both sources — dividends and capital appreciation. Dividends cushion equity investments when markets tank because of broad market factors. For this reason, dividend-paying stocks (along with gold) can be considered as comfort investments; they offer you comfort when your portfolio value declines.
There are two other reasons why dividends can be an important source of returns on your portfolio. Barring unforeseen circumstances, receiving dividends is certain after a company announces the record date for dividend payments. Typically, when the market tanks, such certainty in cash flows becomes an important factor for investors. Therefore, there is good demand for high dividend-paying stocks during such times, especially closer to the record date.
The second reason is psychological. You tend to be more patient with your investment when it has already earned some returns or is expected to offer fixed cash flows. So, receiving dividends will encourage you to hold dividend-paying stocks for a while even if the market tanks. When the market revives, you may be able to also earn capital appreciation on your investment. Note that dividends will be taxed at your marginal tax rate which may be higher than the tax on capital gains on equity investments.
If income is the primary source of return on your investment, you can give up capital appreciation to enjoy the benefit of stable cash flows. But if the primary source of return on investment is capital appreciation (equity), you should, if possible, aim to also earn income returns. Having two sources of returns makes such investments less risky compared with investments that earn only capital appreciation.
There are two ways in which you can capture dividends. You can directly invest in shares after a company announces dividends. Note that dividend yield (dividends upon current market price) should be at least 4-5% if you want to build some cushion to reduce risk on your equity investments. Alternatively, you can buy equity funds that invest in high dividend-yield stocks.
(The author offers training programmes for individuals to manage their personal investments)
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