Last week we discussed what happens to money you save. Money in the bank looks exactly like money hidden somewhere in your house – think banknotes and coins. You can lend your money to someone else for a fee, called interest. You know how much interest you’ll earn, because you agree on a rate when you save your money. There are no surprises when you take your money out. A stack of banknotes doesn’t get smaller over time, but the stack of things you can buy does. If the interest you earn is less than inflation, you are getting poorer.
Investments don’t behave like savings, because money you put into an investment stops being money. When you exchange notes and coins for an asset, you’ve invested. An asset is something you own that can earn you money. Assets can be physical, like owning a franchise. You also get paper assets, like a share in a huge company.
Investing in the stock market is a way of turning your cash into paper assets called shares. You make money holding a share in one of two ways. This week we explain the first way, namely dividends. Next week we’ll delve into selling an asset for a profit.
Sharing the loot
As we’ve explained before, listed companies are just small businesses that got big. The owner of a small business gets to decide what the business should do every day and keeps all the profit the business makes. When you buy a share, you literally become one of the owners of the company. As one of the owners, you are entitled to be involved in the management of the company* and a share of the profit the company makes.
When your company makes a profit, the management decides on the best use of the profit. Sometimes all the profit gets paid to shareholders. Other times some of the profit is used to grow the business while the rest is paid to shareholders. Companies aren’t required by law to share profits with investors at all, but if a company doesn’t make or share profit and also doesn’t grow, investors will sell their shares in the company.
The part of the profit you receive as a shareholder is called a dividend. Each share gets the same dividend amount, so the more shares you have, the more dividends you get. The dividend amount is determined by the management of the company. Although it’s expressed as cents per share, the dividend amount isn’t related to the share price.
What does a dividend look like?
You might think a dividend is one of those “paper assets” we were talking about before, but they’re not. Dividends get paid into your share account in cash. You can either withdraw the dividends and spend that money or turn that money into assets again. It’s generally a great idea to use your dividends to buy more shares that can earn more dividends that can buy more shares…
Using your dividends to buy more shares is how share investments compound over time.
Beware the tax man
You pay a 20% tax on dividends that gets deducted before the dividend is paid to you. This amount seems like very little if you’re just starting out, but as your portfolio grows this will become an important consideration.
*You might be excited by the idea of getting involved in the management of the companies you love, but listed companies typically have thousands of shareholders. For that reason, each share entitles the shareholder to a vote.
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