Do you know your odds?

This Saturday (April 14th) sees the 175th running of the Grand National, the most famous jump race in the world. With thrills and spills throughout its 4-mile, 4-furlong length, the Grand National is something of a national institution. Nearly 10 million people up and down the country are expected to tune in. Beyond the obvious excitement of the race itself, part of the allure of the Grand National lies in the breadth of the field and the subsequent variety in the odds available.

With 50 horses competing, there is a sense that this is a race that anyone can win. In 1967, Foinavon was 100/1 at the start of the race, lagged all the way through but won after a huge pile up at the twenty-third fence, which is now named after him! It is perhaps apt then, that the first ever winner of the race was named “Lottery”. Today, even the current favourite is priced at potentially highly rewarding odds of 11/1.

The Grand National is a tricky race to call, with the favourite winning in just nine of the races since the Second World War. In general though, bookmakers have a much better track record of picking the winner across all horse races. Although stats vary depending on the type of race, on average the favourite wins outright about one third of the time. However, betting on the favourite consistently has not been a money spinner. A £1 stake on the favourite in every race in the UK over the last five years would have resulted in you losing somewhere in the region of 5-8% of your money over the time period. Obviously, this is because bookmakers offer different odds on different horses, depending on how good they think they are, with a view to making a profit themselves. This difference in pricing depending on odds of success is very similar to what happens in the stock market.

As income investors, we are aware that there is a huge wealth of data to provide evidence of the power of dividends as a way to outperform the market over time. However, this is not just as simple as investing in high yield stocks. Indeed, high yields usually spell trouble for income! Realised income from investing in high yield stocks has been significantly lower than forecast historically, and actually much lower than investing in safer stocks with less forecast income – as the chart below illustrates.

The reason for this, is that a high yield can often be a sign of a company in trouble, and where the dividend is likely to be cut to provide cash to support an underlying weak business.

Now, you might think that although the dividend is about to be cut, buying these stocks here might be the perfect time to pick up assets that other investors have panicked out of at prices below their intrinsic worth. However, evidence would suggest that we are not compensated for our lack of income with excess share price returns either. Indeed, much like backing favourites in horse racing, investing in high yield stocks has historically been a fairly sure way of underperforming the wider market – demonstrated below by the experience in the USA, the world’s biggest market.

A high dividend yield is often a sign of the historic success of a company, and as one of the greatest investors of them all, Warren Buffett, delights in saying, “If past history was all that is needed to play the game of money, the richest people in the world would be librarians.”

Harnessing the tailwind of dividends is a powerful way to build wealth in the equity market. However, it requires forward-looking analysis of companies and their ability to sustain and grow distributions to shareholders into the future. Rather than chasing high yields today, patient investors are often better rewarded by investing in stocks that pay a notionally lower headline yield today, but have the commitment and ability to grow that dividend over time. Similar to horse racing, it’s about backing those that can deliver.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.