Why Do Some People Like Dividends So Much?

by: Mark Bern, CFA

Summary

Comparing total return over multiple periods for the S&P 500 and the S&P 500 Dividend Aristocrats may answer at least part of the question.

Planning for retirement? Do rising dividends play an important part in that plan?

Three methods commonly used to reinvest dividends.

I have included the value of dividends in several of my articles but decided it was time to write an article that focused on the subject. In order to provide full disclosure, as I was researching the topic I came across an article in Market Watch that is short and to the point that may might appreciate. There will be some parallels in the early portion of my article relative to that article but I just wanted to expand on the topic so that readers can understand the full impact that dividends can have over the long term.

To provide a little context I went to the horse's mouth, so to speak, and looked up total return for the S&P 500 (with dividends reinvested) compared to the S&P 500 Index return without dividends (just the appreciation) at the S&P Dow Jones Indices site indexology.com. Below is the chart provided:

This was over a period of 25 years so it is considered long-term. This is using just the S&P 500 Index without any selectivity using a passive investing strategy. The results provided were as follows:

" One thousand dollars invested in the S&P 500 at the end of January, 1988 would have been worth $5557 at the end of July, 2013. However, if the dividends were reinvested in the index, the investment would be worth $10,635 by the end of July. Reinvesting the dividends roughly doubled the value of the investment. Looking at the same time period, the annual return earned by the total return index was 9.71% and by the price index was 6.96%, a spread of 2.75%."

That 2.75 percent may not seem like much, but it adds up over time. It also equals 28.3 percent of the total return and is 39.5 percent higher than the appreciation of the index alone. So, if you are not reinvesting your dividends (assuming you are not retired and needing the current income) you may be missing out on a lot of additional return.

Now let's look at how the first article I linked to displayed the comparison. In that article, there was an added parameter: using only the Dividend Aristocrats (at least 25 years of rising dividends) of the S&P 500 total return (with dividends reinvested) compared with the entire S&P 500 index total return (this would be equal to the higher return in the above example). The author provided the comparison over the following time periods: 2016 YTD, three years, five years, ten years, fifteen years and 20 years (but only included the last four in chart form from FactSet).

For five years:

Source of chart: Market Watch

For ten years:

Source of chart: Market Watch

For fifteen years:

Source of chart: Market Watch

For Twenty years:

Source of chart: Market Watch

Now the table included in that article also highlights the differences but I will merely include the percentage increase in total return between the two approaches.

Time

YTD

Three Years

Five years

Ten Years

Fifteen Years

Twenty Years

% Difference

69.9%

17.6%

14.7%

42.7%

53.0%

36.6%

Notice that once we get past the five year period (which in the scheme of things is relative short) the improvement becomes more significant and elevated compared to the three and five year periods. Of course, the whole idea of that article is probably to get people to invest in dividend aristocrats now, after the big outperformance during 2016, but that is probably not such a good idea. Investing today in what was hot just recently in hopes that the momentum will continue usually does not pay off in the short run. It would be best to take a better approach, something I will get into later in this article.

Now let's take a look at the very long term just to make sure we are not looking at a temporary trend. Here is a nice little (free) tool that you can use to calculate returns on the S&P 500 over any period you desire (calendar years only) all the way back to 1871. It only calculates full calendar year returns as in January 1, 19XX to December 31, 21XX. But it will calculate the average total return and the CAGR (compound annual growth rate) with or without dividends. So, I used a 50-year period from 1966 through 2015 (inclusive) in my first round. These results do not include any selectivity (using a sub-group from the index); just the index as a whole (again, passive investing). If an investor had invested in the S&P 500 over that 50 years and just let it ride collecting dividends and not reinvesting them s/he would have received a total CAGR of 6.39 percent and $10,000 would have grown to $221,100. Had s/he reinvested the dividends the CAGR would have increased to 9.69 percent and $10,000 would have grown to $1,021,700. Notice the difference that the dividends make? The average difference in CAGR with dividends reinvested increases by 3.3 percent or an improvement of 51.6 percent. Over an investing lifetime (which could be as short as 30 years or as long as 60 year, and is some cases longer) the difference becomes more and more apparent.

So next I did the same calculation comparing the CAGR for the S&P 500 without dividends reinvested and again with dividends reinvested for 30 years, 40 years, 60 years and 70 years (for those of you really young folks just getting started) and put the results in table form below (including the results for 50 years) all ending in 2015. CAGR w/o Div. means just the appreciation of the S&P 500 index without dividend reinvested, CAGR Div. Reinv is the total return including dividends reinvested, Difference is just the first CAGR subtracted from the second result, the Percent of Increase is the percentage improvement derived from reinvesting dividends and the column labeled $10,000 w/o turns into shows what that amount invested in the beginning (with no additional investments) would turn into over the Time Period without dividends reinvested and you can guess what the last column is.

Time Period

CAGR w/o Div.

CAGR Div. Reinvested

Difference

Percent of Increase

$10,000 w/o turns into

$10,000 w/ Div. Rein. Turns into

30 Years

7.86%

10.42%

2.56%

32.6%

$96,700

$195,400

40 Years

8.11%

11.37%

3.26%

40.2%

$226,600

$743,000

50 Years

6.39%

9.69%

3.30%

51.6%

$221,100

$1,021,700

60 Years

6.56%

9.94%

3.38%

51.5%

$452,500

$2,947,400

70 Years

6.99%

10.80%

3.81%

54.5%

$1,134,000

$13,104,600

There are at least three things should stand out when looking at this table. The least obvious is that without reinvested dividends an investor would have actually made less money in 50 years as opposed to having invested over 40 years. How can this be? The answer is that the 1970s were terrible as a whole and that the index was actually lower at the end of 1975 (90.19) than it was at the beginning of 1966 (92.88). So, without reinvesting the dividends an investor would have lost money during that decade and many did. But those who hung in there and reinvested dividends actually increased their respective net worth by $278,700 or 37.5 percent (not great but much better than the alternative).

The second thing one should notice is that the longer you keep your money invested the more time works in your favor. This is called the effect of compound interest, or sometimes referred to as the "Eighth Wonder of the World." And rightly so. The take away from this concept is that as you build your nest egg it works for you and the more you have the more it works in your favor. This is the basic reason why the rich always seem to get richer (until the prodigal son/daughter comes along, anyway). Getting there is not so hard, it just takes time to get there, something that most investors are too impatient to achieve.

The third thing that stands out is how much difference just a three percent or so increase in CAGR can make over time. Notice how much faster an investor increased $10,000 into $1 million with dividends reinvested; 50 years may be a long time but it sure beats 70 years in my book.

Another thing that some will notice is that there seems to be greater consistency in the improvement in CAGR when reinvesting dividends the longer the period examined. There are two pieces to that puzzle that should be mentioned. First and before readers point it out, dividend yield used to be much higher in the earlier portion of the period(s) examined. That does help some. But do not forget that even after only ten years, in the earlier table, the improvement was already consistently well above 30% and the worst period longer than that looked at (30 years) showed an improvement of 32.6%. The other piece is that, over time, dividends come into favor and then go out of favor in terms of investing styles and company emphasis. During the 1990s there was little regard paid dividends by most investors and, in the end, the price was paid. There was also little incentive for managements to use higher dividend increases as an inducement to get investors' attention; it was not working. So dividend increases were, on average lower. But over the last few years, with bond yields scarce and investors chasing yields aggressively, companies have been increasing dividends at a torrid pace.

These cycles come and go, but the point is that it pays to invest in dividend paying stocks that have a great record of increasing dividends over time. When management is committed to returning cash to its shareholders and those shareholders reward those respective companies by reinvesting those dividends everybody wins, especially the shareholders.

There are two more aspects of dividend investing that I want to cover but I am afraid that if I continued here this article would end up being too long. So, I will just have to write another article or two in order to provide the complete picture of how advantageous it is to pay attention to dividends when investing. The first one was briefly touched upon earlier in the article but I feel it necessary to expand upon the concept for investors to comprehend how important it can be and how much of a difference it can make. The concept is selectivity. Most of this article was about passively investing and how much difference reinvesting dividends can make over time. The next article will focus more on how to add another layer of outperformance on top of that already impressive improvement by understanding how to select long-term winners.

The other piece of the puzzle that I want to cover is how advantageous it can be to add more money to the pot periodically over time. The three methods that I have used successfully (I will dispense with those methods that did not work for me; trust me, I tried them all early in my investing career) are buying the dips, dollar cost averaging and only buying deep bargains (usually called value investing). I will cover each of these concepts in greater detail an article(s) in the next week or two. I want to take the time to use actual examples so readers can follow along and visualize what can be achieved by using each method over time. That will take some work on my part but I think it will be beneficial for readers.

Conclusion

Paying attention to dividends can make a big difference to investors over the long term. The added increase to a portfolio's CAGR provided by reinvested dividends can add hundreds of thousands of dollars in value to a portfolio over a lifetime. Why would anyone not do this?

As always, I welcome comments and will try to address any concerns or questions either in the comments section or in a future article as soon as I can. The great thing about Seeking Alpha is that we can agree to disagree and, through respectful discussion, learn from each other's experience and knowledge.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.