Maybe a Horse Racing analogy will help those who are struggling with the notions or Risk and Reward.
A gambler decides to bet on a horse in a particular race upon which a bookmaker is offering 5/1. He has looked at the horse’s capabilities – stamina, finishing speed, form in previous races … etc … etc … – and has concluded that this selection is most likely to win. Whilst he is doing all this thinking, the horse is quietly munching its oats in its stable, or maybe parading before its adoring public. However, before our gambler gets to the bookmaker’s window to place the bet, the odds have changed and are now only 3/1. Does this mean that the horse is now
more likely to win? Has its form changed? Does it have more stamina? A higher finishing speed? No of course not! All that has happened is that more of the betting public have come to the same conclusion as our rather tardy gambler friend and, by putting their money down first, have forced the bookmaker to alter the reward on offer.
The horse has not changed at all! The chances of this horse winning the race are exactly the same at 3/1, as they were at 5/1!
Moving back to equities and particularly the chance of a dividend cut. The chances of such a cut lie entirely within the makeup of the company in question – debt levels, earnings safety … etc … etc … The risk of a dividend cut is absolutely
NOT AFFECTED by the possible reward on offer! All that changes is the level of possible
Reward demanded/offered by the market.
Once again with the horse race ……..
While making the original selection of the horse at 5/1, our gambler friend also reviewed and rejected a second horse, where the bookmaker was offering only 3/1. Our gambler was concerned about the horse’s capabilities - lack of stamina, lack of finishing speed, indifferent form … etc … Was this second horse more likely to win this race?
Well, on the face of it no, not according to our gambler friend! He believed that his selection would win the race, that is why he made his selection. However, there were others of the betting public that disagreed with our gambler friend, preferring the chances of the 3/1 selection. So much so, they were willing to accept a lower possible reward! However, in order to make one's own determination as to which of these two horses are more likely to win the race, one must look at the capabilities of each one. The difference in odds simply means that the 3/1 shot is
more favoured by the betting public than our gambler friend’s 5/1 selection.
Back to our High Yield Equities …….
An offered possible reward of say 8.00%, when compared with another offered possible reward of say 6.00%, simply means that the investing public is demanding a higher possible reward for the former. To determine the chances of a dividend cut, one must look at each possible selection in detail. And who knows, it is entirely possible that that one may conclude that the offered possible reward of 6.00%, is less safe than the 8.00%!
In other words, the yield on offer, on its own, tells one nothing about the safety or otherwise of the dividend which one is obviously hoping will provide the reward that we all expect from investing in High Yield shares. All it tells one is that the reward demanded/offered for a high yield is greater than for a low yield.
Furthermore, and my apologies for the repetition:
The level of Yield of a given share is NOT A MEASURE OF RISK. Rather it is A MEASURE OF REWARD being offered for taking that risk.
I am somewhat surprised by the fact that certain individuals on this forum, particularly here on the High Yield Portfolio (HYP) board, do not appear to understand what I suspect is one of the simplest notions of Risk and Reward. But on the other hand, what do I care? I mean, it’s not my money such ignorance is affecting!
Each to their own, as they say!
Ian