I came across a rather interesting simulation of index investing. It tries to bring readers into a discussion whether you would want the index of which your unit trust or exchange traded fund is benchmarked to, to rise or fall within the next near term time frame.
We all suffer from the psychological problem of feeling more pain seeing the market value of what we own fall drastically from $100k to $50k. You might say you are ready for it, but nothing prepares you from the actual ordeal. 8 out of 10 of those long term investors who believe they can take large 50% volatility swings will be cutting losses. Many will exit the game all together.
Conversely, it makes you feel like a god when you see a drastic tripling of the market value of your holdings, you start thinking whether the market is overvalued and you should be selling.
Jesse in Why a 66% Crash would be better than a 200% rise explains that, if you are accumulating for retirement, it makes sense to see a market crash of epic proportions in the next 1 or 2 years.
The most interesting fact is the simulation takes place when there is a plunge and the price NEVER recovers to the high price:
Surprisingly, you would end up wealthier at retirement if the plunge occurred. This is true even if we assume that the plunge lasts forever, and that you add no new money to the market as prices fall.
An index is an aggregation of some of the biggest companies in the country or region. These companies pay dividends. With population growth, economic growth, inflation, dividends will grow. Jesse assumes that the dividend yield starting was 3% and this dividend grows at 2% per year.
Why does it outperform the situation when the market goes up 200%?
- The dividends are reinvested to buy more shares. If you have something good, wouldn’t you want to buy at cheaper price. The same concept here. The plunge allows the wealth builder to buy at a much cheaper price per share
- Dividends are increasing and a plunge makes you buy MORE shares early. The wealth builder uses the dividends to purchase more shares at lower prices. 20 years later, each of these shares dividend per share have grown that he has more money to be reinvested.
- Time. The plunge situation takes some time to eventually catch up
STI ETF from 2002 to 2014
One thing i find the simulation unrealistic is that, under no circumstances does the dividend per share went down. Its not realistic because, during recession, the underlying companies that make up the index makes less money and thus the payout should be reduce.
What Jesse is illustrating is that, over time, the growth rate of all this dividend ups and downs evens out to 2%.
In the Singapore context, the closest illustration to something near this is the period from 2008 to today, where on an average 2008 ranks amongst the high of 3500 to 3800, which has not been attained for the past 6 to 7 years.
The price trend looks vastly different from the major European or the USA markets, in that, they have yet to breach the old highs.
I have tabulated the corresponding annualized dividend yield. For 2014, the STI ETF have not declared the second half dividend, though i suspect it will be 5 cent bringing the annual amount to be 9.3 cents.
Corresponding to the dividends, I have tabulate the index ETF price at June one year ago. Why one year ago? This is because this dividend declaration should be with respect to what was earned in the last work year.
Dividends do not increase yearly
One thing we realize is that the dividend growth correspond to the direction of the market index. If index falls, so does the corresponding dividend per share.
Annual Dividend Yield per year averages 3%
One interesting thing i didn’t realize is that the dividend yield for most year is around 3%. The problem with individual dividend stocks is that you have to continue to prospect your existing business or new businesses when the business gets overvalued. You don’t want to purchase an IPAD for $2000.
So its really good to know that the dividend returns whichever year you get invested is usually around that range. This is not a guarantee. This is just an observation!
Reinvested Dividends and Returns
The last 2 columns tries to replicate what Jesse attempted to do in the article. Starting with 1000 shares, what if the wealth builder reinvest all of the dividends.
At the end of 2014, the value of all the dividends reinvested actually ends up higher than the starting price, which is at the peak of the past 14 years.
If you look at the column the right, the index growth and dividend growth are all negative compounded, so to eek out a 1% compounded growth in market value is rather good.
Will this correspond to Jesse results? We are not sure. This result will not make a lot of fans to put their money in STI ETF. They can get more returns from insurance endowment policies.
However, this is a long consolidation, I am not making prediction, but if it ends up breaching the old highs some years down the road, you would be happy that you have more years to accumulate at these lower prices.
If we view the full data from 2002 to 2014, the reinvested total returns look rather respectable.
Sans a few years, majority of the annual dividend yield is around 2.8-3%. (I really don’t understand why 2005 it was that low)
Is this applicable to individual stocks? This is more applicable to a basket of stocks such as the STI because weak performers get replace while sometimes its hard to find a company that continues to be around for decades. You always have to continue to prospect the business, value and risk.
I hope this article lets readers understand that there is a reason why Warren Buffett wants the share price of IBM to remain low. It is that he understand he is holding on to something whose intrinsic value is much higher than current price. If its an IPAD selling for $100, many would be snapping it up. The situation is similar to IBM or a basket of quality Singapore companies.
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