Let the Dividends Roll

Dividend reinvestment is a quiet but powerful force

Although our instincts tell us that to earn more we must do more, the opposite is sometimes true. We discussed this idea as it relates to a buy-and-hold strategy in an article earlier this year. This time let’s look at how doing less relates to dividends.

When corporations pay out dividends each quarter, it can feel pretty anticlimactic for investors. After all, the dividend yield on the S&P 500 was a bit less than two percent of the stock price from 2000-2010. Compared to the 20-30 percent annual price appreciation that a satisfying bull market may produce, a few percent in dividends hardly seems to matter. But it does.

Dividends have a profound and surprising impact on total return, especially over the long term. The chart above shows the price growth of the S&P 500 index (blue line) – a dollar invested in 1950 grew to $60+ in 2010. That’s buy and hold in action.

But an investor who bought and held AND reinvested all dividends over that same period turned that impressive 60x return into 500x (orange line).* Reinvesting all dividends multiplied the total ending value by more than 8 times. Even over a shorter timeframe of 1985 to 2010 when dividend yields were lower than in earlier decades, dividends doubled the total ending value.

Total return

The return on a stock has two components: price change and dividends. Price changes get most of the attention, but dividend yield often does much of the work. The S&P historical return chart below shows that dividends actually contributed more to total return than price change in two of the last six decades.

Components of S&P 500 Return 1950-2009

Dividend reinvestment makes a big impact by steadily increasing the number of shares owned. By holding more and more shares that generate dividends each quarter (and hopefully rise in price as well), an investor who reinvests all dividends can reap very significant long-term benefits. Reinvestment keeps money working no matter what stock prices are doing.

Keep in mind that the impact of dividend reinvestment portrayed above is based not on the selection of specialized high yield funds or handpicked individual stocks but on the S&P 500, a very broad collection of large cap US stocks. Chasing high yields can be tempting, but can result in undesirable overconcentration in specific companies or industries and other portfolio imbalances.

Easily done

Dividend reinvestment can multiply overall return, and it is easily activated. It requires only a one-time instruction to your investment advisor. Of course you must forego the spendable cash flow that dividends would constitute if not reinvested.

Investing often seems difficult, but dividend reinvestment is a good example of how you can earn more by doing less.

* Note that this chart is plotted on a logarithmic scale, which visually condenses large differences in value on the Y-axis. The log scale helps to more clearly present data that vary by many orders of magnitude.

© 2011 Bright Sky Group, LLC. All rights reserved.

Bright Sky Group, LLC is not a registered investment adviser. The views expressed by Bright Sky Group represent the opinions of members of Bright Sky Group, but should not be construed as financial or investment advice. Further, the views are subject to change and are not intended as a forecast or guarantee of future results. The material provided by Bright Sky Group is for informational purposes only. Statements of future expectations, estimates or projections, and other forward looking statements are based on available information deemed reliable, but the accuracy of such information cannot be guaranteed. Statements are based on assumptions that may involve known and unknown risks and uncertainties. Past performance is not indicative of future results.

Bright Sky Group member firms are each registered investment advisers, which are owned and operated independently from each other. Bright Sky Group provides general financial information. The services, securities and financial instruments described by Bright Sky Group may not be available to or suitable for you, and not all strategies are appropriate at all times. The value and income of any of the securities or financial instruments mentioned herein can fall as well as rise, and an investor may get back less than he or she invested. Foreign-currency denominated securities and financial instruments are subject to fluctuations in exchange rates that could have a positive or adverse affect on the value, price or income of such securities and financial instruments. Independent advice should be sought for an investor’s specific needs.

S&P 500 data is based on the period January 1, 1950 to December 31, 2009 and does not account for transaction costs. Source: www.simplestockinvesting.com

An investment cannot be made directly in an index.