Easy Finance 4U

If you listen to bankers and politicians, what we really need right now if for banks to start lending again. Then, all the problems we now see; house prices falling, stock market panics, mass currency movements, will sort themselves out. It might not happen right away, but, they assure us, it will happen. They are wrong, and here’s why.

The last few years have seen a commodities boom; indeed, many say we have just seen the first stage in a long-term commodity super-cycle boom that still has 5-10 years to run. The result is that right now everyone is focussed on price inflation, as the cost of food, fuel and raw materials have pushed up the prices we pay in shops.

Yet move away from the headline inflation figures for a moment, and look at asset prices. Shares, bonds, house prices, all of them have been declining in value recently. This makes sense, because when raw material prices rise, companies must charge more for their goods, and so generally sell less, and make less profit.

Yet, as bad as things look, they may get a whole lot worse, all because of de-leveraging. For the past decade, and especially since 2001, easy access to credit has allowed hedge funds, investment banks and property tycoons to buy up huge amount of the world assets with borrowed money, all the while bidding up those assets prices.

As long as money stayed cheap, people could buy more assets, as long as people were still buying assets, prices kept going up and as long as prices kept going up, banks were willing to lend as they could always sell the asset themselves if the borrower failed to pay. It was in fact a giant pyramid scheme that depended on new players coming in and buying the assets from the owners with even more borrowed money.

Now however, the game is over. When house prices stopped rising it was a signal that the scheme had run out of new willing players, and so everyone who owned houses or any of the many bonds or stocks that depended on them, could no longer find someone to sell them to. The resulting crash was predictable, but the real problem was just how dependant banks had become on always being able to find new buyers for their asset-backed bonds.

Now, banks have closed the door on new lending, not just for house buyers, but to hedge funds and other investment vehicles. As a result, there is no-one able to pay the market price for their shares, bonds and other assets. This wouldn’t be so much of a problem, but hedge funds must sell assets to meet the now far greater interest payments on their loans, and to return money to investors.

The results of this forced selling have been seen in the recent huge falls of world markets. This isn’t individual investors or pension funds selling up, it’s over-leveraged mutual funds, hedge funds and investment banks having to sell assets to pay the bills. It’s the same for shares, bonds, commodities and even gold. The owners need the cash, so the assets get sold, regardless of fundamentals or price. And it’s only going to get worse, as a result of the vicious circle where a fall in asset prices means more cash is needed, leading to more forced selling.

For the small individual investor, things aren’t nearly so bad. Eventually asset prices will recover, and assuming you don’t trade on margin, no-one can force you to sell at today’s low prices. Unless you need to sell in the next few years, now is the time to hang on tight, and get ready to buy once the forced selling abates.

When most people think about stocks and shares, they tend start out with the idea that you try and buy stocks that are cheap, and then sell them later on when they are more expensive. However, this isn’t the only way to invest and make money from stocks. Today, more and more people are starting to focus on dividends, both as an investment strategy, and also a way of obtaining a steady passive income.

Up until its climax in the dot-com crash of 2001, the prevailing strategy for most stock market funds and individual investors has been to target “growth”, that is, to buy companies that are predicted to grow their earnings faster than the market average. The alterative was “value” investing, where shares are bought based on the idea that companies are “undervalued” due, perhaps to short-term problems or modest growth prospects. Both of these strategies, however, depend on selling a stock at some later date for more than was initially paid for it.

Contrast this to the position of a small business owner, perhaps of a flower shop or restaurant. They will receive money regularly in the form of profits and perhaps be able to live very well off this income alone for most of their lives. In principal, an investor who owns shares in a profitable company is no different than the owner of a profitable shop. True, there are many shareholders to divide the profits amongst, but then McDonalds has a lot more than 1 store!

The fact is that most companies do pay their profits out to shareholders, but few investors pay much attention to them, instead focusing only on the share price. In part this is because most popular growth stocks have low or even no dividends, their price based on future predicted earnings. It doesn’t have to be this way though, there are plenty of large companies available that have long histories of paying out a steadily rising divided to shareholders. Dividend yields (the yearly dividend payout as a percentage of the cost of the share) are available for many large, stable companies at more than 5%, far more than you can make from most savings accounts.

Investing for dividends is a strategy with numerous advantages. The most obvious is that a portfolio full of high-yield companies will be paying you money every year, money that you can either re-invest in more shares, or use to cover unforeseen expenses. This has the additional advantage of reducing the need to sell shares if you require cash, which can be very helpful if current market prices are depressed, as they are currently.

Also, in most countries, dividends are treated more favourably than other forms of income, often because a company will have already paid tax on its profits before it distributes the remaining money to shareholders. Finally, it’s possible to never actually have to sell your shares, after all, why sell something that pays you a steady amount of money every year? Certainly you will often be able to get away with less buying and selling than other investment strategies, which can significantly reduce brokerage costs.

For some investors, the income from dividends can be all the income they need, allowing them to retire early, or work part time, and even if your portfolio never becomes quite that large, the regular dividend payments can act as a powerful incentive to keep investing whatever the economic conditions.