The media sure do love a stock market correction and this one has been labelled “Black Monday”. But while it was definitely on a Monday, was it really all that black?
In case you missed it, the Chinese stock market has crashed. Of more interest to UK investors, the FTSE 100 has fallen by as much as 12% over the last week or so, culminating in a fall of almost 5% on Monday.
The media reaction was predictable, with endless headlines of “reeling markets” in a “devastating” multi-billion pound “meltdown”.
Okay, I get it. Market corrections can be scary, but what should investors actually do?
My contention is that this correction, like most corrections, is likely to be a good investment opportunity.
Why? Because falling share prices increase the dividend yield on most shares and usually lead to higher capital gains in the future.
Market corrections lead to higher dividend yields
Dividends are a major part of the return that investors get from the stock market. The UK market returns something like 7% a year, on average, over the long-term. That 7% return comes from a combination of dividend yield and dividend growth.
Over the last 30 years or so the FTSE 100 has had an average dividend yield of 3.1% and average yearly dividend growth of 6.4%. Together they have produced an underlying return of 9.5% a year.
While nobody knows how fast dividends will grow in the future, we do know that after the FTSE 100’s recent decline its dividend yield stands at 4.1%. That’s almost a third higher than its average for the past 30 years.
If dividend growth in the future is same as it has been in the past then today’s high dividend yield will lead to underlying returns that are a full percentage point above their historic average.
Any reinvested dividends or new money invested would achieve that higher yield and higher rate of return precisely because the market had declined. So for those who are actively investing new money or reinvesting their dividends, this market correction is almost certainly a good thing.
One argument against this line of thinking is the dividend cut. If a company’s share price is falling then it may be because the dividend has been or is about to be cut. In that case there would be no boost to the dividend and no boost to future returns.
That’s true, but in a market correction the shares of…
