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We published an article last week showing how dividend yielding stocks beat the stock market by 5.4% when 10-year interest rates are below 2.5%. Investing in dividend stocks seems like a great idea if interest rates stay below 2.5% for a long time. Unfortunately, we can’t tell the future. Who knows where interest rates will be next month, next year, or the next decade? Let’s take a look at the long-term behavior of this investment strategy.

At the end of every year we picked the 20 highest dividend yielding stocks among the largest 500 stocks (between 1927 and 1950 we limited the universe to the largest 200 stocks, and between 1951 and 1965 the universe was the largest 300 stocks) and kept these stocks in our portfolio for exactly one year. Between 1927 and 2009, high dividend yielding stocks returned an average of 13.04% per year. The value-weighted market return was 11.68% during the same time period. The dividend stocks beat the overall market by an average of 1.36% per year.

This is not negligible. The compounded return for dividend strategy is 3960 vs. 1990 for the broader market. So, investing in dividend stocks is a great idea for long term investing, right? Wait…

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It’s not like dividend stocks beat the broader market by 1.36 percentage points year in and year out. The results vary wildly from year to year. For example, during the 10 year period between 1927 and 1936, dividend stocks underperformed the market by an average of 4.8% and returned less than the broader market in 9 out of 10 years. If there were some dividend stock investors in 1927, they probably would have abandoned this strategy by 1936. During the following 15 years, dividend stocks managed to beat the broader market in 13 out of 15 years and the average outperformance was 5.0%. A complete reversal. Basically, if we exclude the first 10 years, we could say that dividend stocks beat the stock market by 2.2 percentage points on “average”.

High dividend stocks performed much worse than the broader market between 1987 and 1999, underperforming by 7.7 percentage points per year. In 11 out of the 13 years, dividend stocks also returned less than the stock market. This may be the reason why dividend stocks were out of favor at the peak of the dot-com bubble and outperformed the broader market by an average of 10.2% per year during the past decade. Dividend stocks managed to beat the stock market in 9 out of the last 10 years.

If we had done this analysis at the end of 1999, we would have concluded that dividend stocks performed worse than the broader market with cumulative returns of 176,000% vs. 216,000% for the broader stock market. It is obvious that investing in dividend stocks is not statistically different than investing in the broader market. Yes, dividend stocks perform better when interest rates are ultra low, but who can guarantee that interest rates are going to stay this low for an extended period of time.

Disclosure: No positions

Source: Should We Invest in Dividend Stocks for the Long Term?