Making money even when sharemarkets tank

Lower share prices in good quality shares should be welcomed with open arms

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Lower share prices in good quality shares should be welcomed with open arms, writes The  Motley Fool

I recently read this in The Sydney Morning Herald:

"In the Australian stockmarket, every trade is matched. That is to say, for every buyer there's a seller, and for every seller there's a buyer. So for every winner there is a loser. Every dollar someone makes is lost or not gained by someone else."

The last sentence is clearly wrong, and understanding why this is wrong is one of the keys to your long term investing wealth. I will explain why.

Trading versus Investing

Trading, defined simply, is the act of buying and selling shares in the sharemarket. Investing, again defined simply, is committing capital in order to gain a financial return.

When you commit capital by spending money in buying shares, you expect to gain a financial return in two ways.  The most obvious way is by selling the shares at a higher price.  The other, not-so- obvious-way, is when you receive money from the company by way of dividends, buybacks or capital returns.

Looking at this broadly, it is obvious that trading is only one element of investing.

Show Me the Money

Sharemarkets are falling around the globe. During the market panic, The Motley Fool has consistently encouraged investors to buy shares, and not to sell.

But should you buy even if you expect sharemarkets to keep falling?

Yes. In fact, do it now.

At current prices, Commonwealth Bank of Australia (ASX: CBA) and QBE Insurance Group Limited (ASX: QBE) both trade at about 10.5% grossed up dividend yield.  For reasons of simplicity, I will assume a tax rate of 30%.  This means that you will get 7% after tax as dividends from your shares at current prices. You are to reinvest this 7% every year, without fail, into the same shares.

We now look at several scenarios. You can verify the scenarios below with simple spreadsheets.

Scenario 1: The Bear Market is Coming

We assume a full on bear market. The share price of CBA and QBE drop 5% per year for the next 5 years, and then stays flat for 10 years.

The economy is so bad that the dividend is reduced by 10% every year for five years, and then stays flat for 10 years.

At the end of 15 years, every dollar of your initial investment will be worth $1.80, a return of 80%, and this will be providing a dividend yield of 5% per annum.  Not flash, but not end of the world, despite a bear market assumption that mimics the Great Depression in the 1930s.

Scenario 2: Sideways and see saw market

We assume a sideways market. The share price of CBA and QBE drops 10% each year for 2 years, and then oscillates 10% up for one year and 10% down for one year, and this goes on for another 13 years.

The economy is flat and the dividend stays the same for the next 15 years. At the end of 15 years, every dollar you initially invested becomes $2.91, a return of 191%, and your shares are still yielding 7% in dividends.

Scenario 3: Flatline Market

We assume the market stays flat. The share price of CBA and QBE drops 5% each year for 2 years, and then for some unknown reason, stays unchanged for 13 years.

The dividend follows inflation and increases by 3% per annum. At the end of 15 years, every dollar you initially invested becomes $3.69, a 269% return over 15 years, and more importantly, at that time, the shares will be yielding 13.6% per annum in dividends.

Not zero sum

None of the scenarios above assumed a rising share price. In fact, in all 3 scenarios, the shares prices were lower at the end of 15 years, a highly improbable event. Yet, in all 3 scenarios, you as an investor made varying degrees of positive returns, and the returns are generated only from reinvestment of dividends.

If investing is a zero-sum game, how can this be so?  Who has lost money to allow us to make these returns? The answer is nobody, because investing is not a zero-sum game.

Foolish bottom line

A business creates wealth by delivering goods/services of value to customers. Shareholders receive dividends from the profits generated by the business. Every dollar in dividend made by shareholders is not "lost or not gained by someone else."

Understanding this is the key to lifelong investing in quality businesses. Given the power of compounding and reinvestments as illustrated above, it should now be apparent to investors that lower and falling share prices in good quality shares should be welcomed with open arms.

In the meantime, consider this one large company we think has some serious long-term potential. Get this free special report from the Motley Fool – The Best Stock For $100 Oil. Click here to sign up now.

Fool contributor Peter Phan owns shares in QBE. The Motley Fool's disclosure policy never tanks. This article has been authorised by Bruce Jackson.


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