The Valor Blog.
Investment News and Views, Direct from Our Team.

Dividend blindness

For those of you who like to simplify life and believe that having a high dividend yield is the single metric to help you sleep at night with your portfolio, please read this article. Bank of America had a 6% yield and then went on to fall 95% from this level.

In 2007, numerous US banks were talking about the housing market recovering soon and how fantastic their dividend yields of 6% were. Does that sound familiar? Most of them crashed. 

Whilst it is not definite that we will have an exact replica of the American housing crisis, the article above should highlight the media beat up over dividends and ignoring the risks when investing in these highly volatile businesses. The Australian banks do have better capital ratios than many of the US banks before their downturn, but Australia has much higher house prices. (As seen below thanks to Steve Keen)

The Australian banks are approximately 10 times geared. This means they have about 10% equity and 90% debt. Add this to derivative portfolios that are twice the size of the Australian economy for each bank and you have extraordinary complex and risky businesses.

Most mums and dads will just compare the dividend rate to cash and see that it is a few percentage points higher and rush in.

The majority of Australians who live off dividends for retirement in my opinion do not have enough to truly retire. True retirement is having enough money to live off lower risk assets such as government bonds and cash. Those that are needing their dividends from risky assets to live off for their basic needs do not have enough to truly retire. There are very few people who ever make it to this comfortable level.

There were numerous unfortunate news stories during the GFC of people telling their woes of losing their retirement income because their portfolio had dropped so much. These people were living off their risky share investments rather than living off their cash. This sort of market crash will happen again and again over the next century and beyond and those that are fully invested and living off their risky shares will again be burnt.

True retirement is having enough cash to live off for 10 years based on your minimum retirement amount, then invest the rest.

At market peaks, you may need more than this.

Your minimum retirement amount is based on your basic living needs before luxury expenses such as holidays etc.

If you need 40k to live off for your basic needs and if you expect cash returns to average 3% over the next decade then you need $341,208.  This is a very simple present value calculation. This money should be quarantined away and not touched unless there is a market crash. You then live off your cash and dont sell your investments below their true value.

If you are a forced seller of assets during a downturn when you are drawing income, you can destroy capital at a rate that you can never recover from.

In 1929, the market dropped 87% to its lows in 1933. If you were fully invested at this point in time and living off the dividends, you could have been wiped out in a few years.

It took 22 years for the market to recover from its 1929 highs. 1967 took approximately 15 years. 2000 took approximately 13 years. If you are investing in stocks, you must expect far more volatility than many people understand.

For those heavily invested in highly geared entities such as banks, the US banking story of the last 5 years proves that these events are possible. A number of US and european banks no longer exist or are trading at 90% of their pre crisis value. Prepare for the worst, hope for the best.

This method for preparing your retirement assets for the worst market scenario is not only prudent, it is crucial to ensure you have sufficient assets to ride through the wild market fluctuations.

I honestly hope that Australia does not have a downturn in the next few years because there would be a great deal of pain for many retirees. Our share market is unbalanced in its banking and mining dominance. Our super funds have one of the highest exposures to shares in the world and mums and dads have extreme over exposures to banks and miners because that is the dominant force in the media.

Unfortunately this hope is dependent on Australia continuing to ride China’s debt fueled boom. I prefer to be a realist rather than a pure optimist and I still expect this story to play out at some stage over the next few years, and it may not be pretty when it does.