Why Dividends Matter for Long-Term Returns

Discover how dividends contribute to total return, provide steady income and support a long-term investing strategy.

Since 1926, dividends have accounted for more than 40% of the return realized by investing in large-cap stocks. The oft-touted 10.1% historical annual return for stocks is significantly impacted by the payment of dividends. Ibbotson Associates, which tabulates long-term historical returns, says that if dividends were taken out of the equation, the long-term annual return for stocks would fall to a more mundane 5.8%.

Dividends also create a steady stream of portfolio income. They are cash payments distributed to shareholders periodically. Most dividend-paying companies follow a regular calendar schedule for distributing the payments, typically on a quarterly basis. This gives investors a reliable source of income.

This stream of income helps returns. When stock prices move upward, dividends enhance shareholders’ returns. Shareholders get the benefit of a higher stock price and the flow of income; when combined, these elements create total return. Dividend payments provide a minimum rate of return that will be achieved, as long as the company does not alter its dividend policy. This helps cushion the blow of downward market moves.

Dividends are a commitment by a company to distribute a portion of its earnings to shareholders on a regular basis. Once a company starts paying a dividend, it is reluctant to cut or suspend the payments. This commitment puts pressure on corporate executives to make prudent business decisions in order to maintain the stream of dividend payments. As a result, dividends can make companies more shareholder friendly.

The AAII Dividend Investing Strategy

The AAII Dividend Investing portfolio follows a total return strategy. The portfolio invests in stocks that have the potential to rise in price and make larger dividend payments in the future. Rising prices provide the opportunity to realize capital appreciation, which is one part of a stock’s total return. Dividends provide an income component, adding a second part to a stock’s total return. Combined, price appreciation and dividend payments make up the total realized return on an investment, and each part can contribute to increasing it.

For example, assume stock XYZ trades at $20 per share and has an indicated dividend yield of 3%. Over the course of the next 12 months, the stock price rises 10% to $22. During this period, shareholders receive 60 cents in dividends (3% yield times $20 stock price equals 60 cents in dividends). The total return realized by shareholders over this period is 13%. How? Shareholders saw the stock price appreciate by $2 (10%) and received 60 cents in dividends (3% yield), resulting in a total increase of net worth of $2.60. Dividing the $2.60 total increase at the end of the period by the $20 stock price at the beginning of the period equals 13%.

The advantage of total return is that it gives investors the potential for a win-win combination. Net worth is increased by both the change in the stock’s price and the payment of the dividend. Stock prices are unpredictable, of course, so there is no guarantee that the total return will be positive for any specific stock held in the portfolio. But the presence of a dividend provides another component of return in an investor’s favor.

Another way we seek to achieve positive rates of return in the Dividend Investing portfolio is by selecting fundamentally attractive stocks. Stocks selected for the portfolio must possess good business models, strong balance sheets, growth in sales and earnings, positive free cash flow, attractive valuations and a history of rising dividend payments. Each company must also add to the portfolio’s diversification.

Diversification is accomplished in several ways. Companies are selected from a variety of industries and sectors. No minimum market capitalization is required, allowing for the inclusion of companies of differing sizes. Several strategies are used to identify stocks with varying characteristics. Some stocks will have stronger potential for sales and earnings growth, while others will have higher yields.

Companies must also have a reasonable expectation of paying a dividend over the foreseeable future, and we generally look for a history of rising dividend payments. We consider the indicated yield (projected dividend payments for the next 12 months divided by the current share price) for all stocks, but place a greater emphasis on stocks with the potential to enhance the portfolio’s total return than those that merely pay a high dividend. On occasion, we may add a stock that does not have history of rising dividend payments or that has recently instituted a dividend if we believe it has the potential to increase dividends in the future.

The Power of Reinvesting Dividends

Dividends drive future returns by allowing you to accumulate more shares. This process, known as dividend reinvestment, is key to phenomenal wealth creation.

Total return data from research firms S&P, Ibbotson and Ned Davis Research show how wealth quickly grows over long periods by investing in stocks. Performance tables that show return with and without reinvesting dividends demonstrate how the return from reinvesting dividends in a winning company can be staggering. Even Albert Einstein is said to have referred to compounding, which is what reinvesting dividends gives you.

We can’t tell you what Einstein did or did not say, but we can tell you that reinvesting dividends builds wealth. Why? Because you get to buy more shares, which in turn pay you even more dividends, which allow you to buy even more shares, and so on. It’s a simple lesson that people often forget. But let us show you how it works.

Let’s look at a dividend-paying stock that everyone around the globe is familiar with—Coca-Cola. The chart below shows the power of reinvested dividends and how they can lead to phenomenal wealth creation. If you had purchased a single $40 share of Coke when it went public in 1919, it would now be worth roughly $586,000. Not bad, but with its growing dividends reinvested it would be worth approximately $23.4 million today. That’s the power of reinvesting dividends!

Reinvesting Your Dividends

We are big believers in reinvesting dividends, but our first preference is to reinvest the dividend payments into the new stocks that are added to the DI portfolio. This allows using dividends to help rebalance the portfolio. The strategy is simple. Dividend payments from existing holdings are allocated to the DI portfolio’s cash balance to fund future stock purchases. When a stock is deleted, the proceeds and any existing cash in the DI tracking portfolio are used for a replacement stock. (If the total cash available exceeds the average position size for the portfolio, not all of the available cash may be used.)

Should the DI tracking portfolio’s cash balance grow to a significant size, it may be reinvested into some, but not all, of the portfolio’s existing holdings. We are strong believers in the power of reinvesting dividends and want to keep the amount of cash in the DI portfolio to a minimum. You will be alerted in the Weekly Insights email and on the DI website to all planned transactions, including reinvestments, before they are carried out in the DI tracking portfolio.

As a subscriber, you have three options for your cash dividend payments.

• You can set the cash payments aside for future stock purchases when a DI addition alert is published

• You can withdraw the cash for portfolio income

• You can also reinvest the dividends, using them to acquire more shares of the same stock

Withdrawing the cash or immediately reinvesting the cash will result in your portfolio’s performance differing from the returns achieved by the DI portfolio.

Should you choose to reinvest your dividends immediately, your brokerage firm may be able to facilitate the transaction at no charge. Many companies do offer dividend reinvestment programs directly to shareholders, but these programs require extra paperwork and recordkeeping. Going through your broker, if possible, might be the easiest way to reinvest your dividends automatically. Contact your brokerage firm for information, including any potential expenses you may incur.