Take your share and reap the dividends

The investments which make up a balanced long-term portfolio usually involve lending money to someone else, either to the Government, which tends to pay lower returns because it offers investors security, or to a bank or building society, a company which expects to be able to reinvest your money at a profit.

The investments which make up a balanced long-term portfolio usually involve lending money to someone else, either to the Government, which tends to pay lower returns because it offers investors security, or to a bank or building society, a company which expects to be able to reinvest your money at a profit.

So by definition you are getting less than it would cost you to borrow and having a margin of profit for someone else. The only way to share the profit in full is to become a shareholder, and take your share of the profits and the losses of the companies in which you invest.

All shareholders have rights, but small shareholders individually cannot hope to influence the management, which decides on the company's investment and trading policy and on how much money to pay the shareholders in dividends.

Companies make profits which are often expressed as earnings after paying corporation tax, interest on borrowed money and dividends on preference shares, and often calculated as earnings per share. They can sometimes pay dividends that are greater than earnings in order to reassure shareholders but in general most will pay out only about half the earnings in dividends, and companies set on fast expansion may retain a much larger share of earnings.

Traditionally companies have tended to raise their dividends from year to year or to follow a progressive dividend policy. But investors are at least as much interested in profits as they are in capital gains as these are more lightly taxed than dividends.

When inflation rates are high, dividends are important to provide investors with some protection against falling values of money, but when inflation is low and falling dividends are less important, the prospects for real growth are greater and capital gains are more likely.

Last year for example a portfolio of the top 100 UK shares would have provided a total return of around 24 per cent, of which 21 per cent was capital gain and less than three per cent was from dividends.

Shares rise and fall in price from minute to minute as big investment houses, pension funds and professional analysts rate and re-rate the shares and anticipate the profits and the growth prospects relative to the general levels of growth of the company, the industry in which it is based, the national economy and increasingly the wider world economy.

Markets can double and halve over a period of two or three years and individual shares can and do rise and fall by 30 per cent to 50 per cent in a matter of months and 5 to 10 per cent in a single day, sometimes without any obvious reason. But over most periods of five years or so, shares have risen consistently faster than other investments, and faster than inflation.

Portfolio theory allows analysts to break down share markets into different sectors and then to individual shares all of which have their own risk and return profiles, volatility and correlation characteristics, while foreign markets do not always move in step with London. It is not always necessary or wise to concentrate on a few risky shares or a single sector of the market such as high technology stocks that seem to be going up like a rocket. Sooner or later they will overshoot and come down again.

The secret of success is to have a mixture of shares and preferably some with exposure in markets outside the UK in the portfolio, or failing that a unit trust or investments trusts that invest in a range of shares, and to invest and be patient.

Property is another kind of investment altogether. Commercial property, shops, offices, factories and retail parks, have earned good returns from both rents and capital gains, but the individual units are too large for small investors to buy, and property unit trusts have not caught on in the UK. Small investors can buy a stake by investing in the shares of specialised property companies, although most have under-performed the stock market as a whole, presumably because they eat up too much of the profits in administration charges.

Residential property is much more to the taste of UK investors. You can live in your own house or flat, but it takes longer and is more expensive to buy and sell than bonds or shares, and there is no daily market price to tell you whether you are getting the best current price. Property also costs money to maintain. But apart from the period of negative equity a decade ago, when property prices fell leaving many recent buyers unable to sell because they could not afford to pay off the mortgage, property has proved a good investment and is much less volatile than shares.

In some parts of the country there are houses where no one wants to live, and prices have slumped. But in most places there is an ongoing shortage of houses, and the recent floods may make the situation worse by discouraging new building on flood plains. The market in investment property is also growing, offering the chance to earn an income as well as capital gains in return for the hassle of managing as well as maintaining the property.

Next week we shall look at the ways of putting together balanced portfolios suitable for a variety of long-term investors based on their attitudes to risk and their time horizons.

Clifford German is a joint author of 'Fortune Strategy' published by Pearson Education