Stock high but it’s a risky ride

Why put your money in the bank when you can get a higher return by owning a tiny piece of it?

Why put your money in the bank when you can get a higher return by owning a tiny piece of it?

This is a popular idea doing the rounds and, on a superficial level, it makes some sense.

When term deposits are only paying an average of 3.5 per cent a year, people in higher tax brackets are going backwards once tax and inflation are taken into account.

Bank shares, on the other hand, have a far more attractive yield, thanks to the fat dividends on offer.

The Commonwealth Bank’s gross yield, including franking credits, is 6.6 per cent, according to Bloomberg. It’s even higher at the other big banks, as this week’s graph shows.

Before rushing out to buy bank shares, however, it’s important to understand that there are significant differences between putting your money in a bank and investing in one. The most obvious difference is security of your money.

While all deposits up to $250,000 are guaranteed by the government, shares in any company, including banks, are volatile.

Even a fairly small market correction can wipe out a year’s worth of dividend payments in no time.

It can be easy to forget this at a time when bank share prices are climbing ever higher, but it’s a critical point to remember.

In short, it would be foolish to look only at the yield on offer from blue-chip shares, even the banks, without considering the risk.

Sure, banks are enormous financial institutions that are implicitly guaranteed by the government, but that shouldn’t protect equity investors in the company. (That’s the theory.)

When the global financial crisis struck, the Commonwealth Bank’s value fell by more than 50 per cent from its pre-GFC peak, while deposits it was holding were safe and continued to pay interest.

This is not a prediction that the same thing will happen again, but some analysts argue that after the meteoric rise in bank shares, the capital gains may be reaching their limit.

UBS analyst, Jonathan Mott, points out that, in the past 15 months, bank shares have delivered shareholder returns (dividends plus capital gains) of 50 per cent. Most would agree that’s not sustainable.

He says the ratio of price to earnings – a common way to value stocks – is also at a record high.

None of this is to say the banks are a bad investment. They’ve become a sharemarket darling because of their ability to churn out ever higher dividends.

But it’s probably not the right strategy if you need your capital to be secured in the short to medium term. As the old adage goes, only invest what you can afford to lose.

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