When you invest in the stock market, whether you are buying shares in only one company or a diversified fund holding hundreds of shares, where is my money going, and what is it doing?
Quite simply, when you buy shares or a portion of shares in any company or companies listed on any of the country stock exchanges, you are buying a partial ownership. This money goes into company coffers to use at their discretion. For example, if you buy 1000 shares of a company having 10,000 outstanding shares, you now own 10% of that company. This ownership entitles you to voting rights in the company’s business and a share of any future capital gains through increased value in the market cap, or part of the income through the distribution of profits to shareholders via dividends. The scarier side is it also entitles you to any losses a company incurs from bad business dealings that erodes the overall market cap. A share price is determined by taking the market cap and dividing it by all the outstanding shares in circulation. For example if there are 10,000 shares in circulation and the market cap is $100,000, then the share price is $100,000/10,000 = $10/share.
So then, you ask, “how can I lose money on a stock?” Well, the obvious way to lose money is to sell it for less than you bought it for. For example, if you bought ABC stock for $10 a share and sold it a week later for $8 a share, you will lose $2 a share on the sale, or take a 20% loss. Evidently, taking frequent losses on investments is an undesirable way to play the market in retirement, and if all you ever do is lose money on your trades, a sure-fire way to erode your savings to zero. Day traders play the market this way, trying to make small gains on daily trades. Sometimes it’s ok to take a small losses. Capital losses in taxed accounts can be used to offset capital gains in taxed accounts to reduce your taxes.
But what if you buy a share for $10 per share, it pays a regular, annual dividend, and you hold it for 10 years? This one share pays you 5% in dividends every year, or $0.50 per year. Assuming you never add more shares, those cash dividends add back into the value of that one share, driving your average cost (ACB) down year over year. In 5 years you have collected $2.50 (5 years X $0.50/yr) in dividends, and this injection of money has driven your average purchase price for that share down by this amount to $10 - $2.50 = $7.50 per share. The average cost is important from the fact that it makes holding onto the share at the lower share prices easier, by helping you overcome the psychological perception of loss during the downward cycles in share price. This effect of averaging down your cost can be compounded if you apply a DRIP (dividend reinvestment plan) to add shares and grow your dividends year over year. In the example I gave, though, you would only be able to buy one more $10 share after holding it for 20 years. But when you do, now you have 2 shares for your original investment of $10 and are getting $1 in dividends per year. So now you can add another share in 10 years instead of 20. You get the picture? Of course, shares in the stock market are traded on a much larger scale and the price/s changes frequently, so calculating average costs is usually calculated and shown for you in the brokerages you are using. But,.. using one share to illustrate the potential to generate escalating value is easier to see and explain.
Not all shares are the same. Some pay dividends while others do not. This is where investing caution, some basic knowledge, and the power of diversification is recommended before putting too much of your money in. There are companies in the stock markets that are just starting out, need capital to grow or maintain their financial performance, and do not want to pay out dividends as a result. They may never pay dividends due to financial uncertainties or their plans to use up all profits, or simply return those profits and value to shareholders in the share price alone. Not all company shares pay dividends, and this can be seen by a quick look into the share details under “dividend yields”. If a share pays dividends, it will be displayed as a dollar value/share/year, and also as a percentage of the current share price. Are these dividend non-payers bad investments? Not necessarily, but a tad more understanding and caution is required to ensure you don’t lose your shirt. There tends to be a little more investment risk associated with companies that have not proven out their business models over time and the ability to stabilize their cash flow and expenses. If they are growing rapidly or borrowed more than they could pay off it is even more risky. The Cannabis industry illustrated this risk over the last few years. Some got rich while others rode the down trend to rags. Sometimes there is a herd mentality where investors buy in to new businesses on pure hype and drive the stock price artificially high or above the fair market valuation, and those who hang on may eventually pay the price due to the ones who cash out rich, or a company’s failure to produce solid financial results. Any bit of bad news can also change sentiment and cause a stock selloff and erosion of the market cap. This causes downward share price pressure. Those that cash out rich take a significant portion of the market cap out of the stock, making the share price collapse, and usually, others jump off the sinking ship and this trend can continue until a technical price resistance is hit. This is usually a technical bottom where the company and some institutional shareholders hold. Lots of people do well buying shares that don’t pay dividends, and good companies (shares) that don’t pay dividends are included in all global index funds, but more volatility is usually associated with these shares. One example of a decent stock with no dividends is Shopify, while another not-so-good stock that doesn’t pay dividends is Gamestop. Both have had bouts of being driven up and down significantly over the last few years, but while Shopify has been driven up on good business fundamentals, Gamestop has been driven up by retail investors simply buying in to screw hedge funds and follow a reddit crowd of revolutionaries. If you want to see what happened with Gamestop, watch the movie “Dumb Money” on Prime Video, or run a 5 year price trend on the stock in Yahoo Finance.
The best way to learn about the stock market is to open an investment account and buy $1000-5000 of any global, index-tracker fund like Vanguard’s VGRO, and just watch it for a year or two. VGRO is distributed evenly in all the major markets. This way you can see how the global market index performs, with a vast mix of both dividend paying and non-dividend paying stocks across the world. Take the dividends and buy more shares in the same fund if and when you can, or simply set up an automated DRIP. But I’d recommend you buy it in a registered account like a FHSA, TFSA, or RRSP to avoid the country taxes on dividends and any capital gains.
If you feel even braver and want to see how one stock with dividends performs, buy $1000-$5000 any of the 5 major banks in Canada. These are blue-chip companies, or companies that have consistently outperformed the market and increased in value since their inception. They have paid dividends out over 50-100+ yrs and never missed or dropped their dividends (not to say never, but history is usually a good predictor of the future). They all pay 4-7% in dividends, are very stable in terms of share price and market cap, and continuously trend up in value over the long term. If you ignore the odd bad year, like lately, they basically double in market cap every 30-40 years, and your average share cost is constantly driven down by the value of the returns from the dividends. Every now and then there are events that drive further value, like a dividend increase, or when the company buys back it’s own shares, or they split their stock giving you 2:1 or some other ratio on the split. Canadian banks implement all these tactics fairly regularily to increase shareholder value.
When a company buys it’s own stock back, it takes shares out of circulation in the market, and therefore the company removes the associated dividends it would otherwise have to pay out to shareholders. It also removes the number of available shares for purchase, which increases the value of available shares. The net effect of this event is a positive increase in revenue and market cap, and it may even signal a potential dividend increase for loyal shareholders down the road.
When a company splits it’s stock, they effectively issue more stock to current shareholders at a value that is divisable by the extra shares. For example, if the stock is $100 and splits 2:1, then shareholders on record on a certain date will get 2 shares for every 1 share they own at half the price before the split, or $100/2 = $50. The dividends are also halved with these shares. The overall capital value and dividend value doesn’t change for existing shareholders, but now you have double the shares. Companies do this to make shares more affordable for others to buy in, while at same time rewarding existing shareholders with the new buying activity usually generated by this event.
What is your money doing? When you buy shares you are investing in a business. They use your money, either wisely or unwisely, to make you more money through share price increases and/or dividends increases. You can decrease your risk through diversification or buying into shares with proven business models and long standing reputations for increasing shareholder value. Some think this is boring, but in retirement you want to keep it boring. Too much excitement one way or the other encourages mistakes!
In my perfect retirement world, the share or fund price continues to drop conservatively in average cost, while the dividends from our investments fund a majority of our retirement income and continue to enjoy the odd increase to offset inflation. The lowering ACB (average cost basis) makes selling shares at lower share pricesto fund our retirement income easier to stomach over the long term. Easy to say, but harder to put into practice due to all the moving parts; the stock market volatility, registered account withdrawal rules, taxation, etc. Our government pension programs (CPP and OAS) will eventually shore up our income that is lost through the annual drawdown of our RIFs and LIFs , when we elect to take them. You can only defer CPP and OAS til you turn 70. For now we are deferring CPP and OAS to 65 and beyond, and it all seems to be working so far according to plan.
This year is another change year, where we decided to switch up our portfolio structure and withdrawal plans. In 2024 we are taking more out of our registered accounts on an monthly basis, above the annual minimums, in order to pay withholding tax and get away from the large tax-owing costs (tax instalments) set by the CRA. We also changed up the investment mix inside our portfolio to pay us more to cover the higher withdrawal rates, although at some point in the next 8-13 years we’ll need to get our registered accounts closer to halved in value to make room for the extra CPP and OAS income.