Forget hot growth stocks:
Dividends determine profits
Investors these days seem to focus on growth stocks and capital gains. Yet the humble stock dividend has contributed greatly to positive stock market returns over the last 80 years.
With dividends currently at historically low levels it is easy to forget their long-term importance.
Yet almost half of the U.S. stock market’s return since 1926 has come from dividends, not from capital growth, says John Bogle, retired chairman of the Vanguard Group, the largest mutual fund family.
“When we take inflation into account, the importance of dividend income is magnified even further,” he wrote in the Journal of Indexes. With an average inflation rate of 3.3% since 1926, “dividend income has accounted for almost 75 percent of the annual investment return on stocks.”
Compounding growth
Bogle offers a remarkable example. An investment of $10,000 into the Standard & Poor’s 500 Index in 1926 would have grown to an astounding $33.1 million by late 2007 if all dividends had been reinvested.
But an investor who did not reinvest dividends would have a final value of just $1.2 million, “an amazing gap of $32 million,” Bogle says.
“Over the past 81 years, then, reinvested dividend income accounted for approximately 95% of the compound long-term return earned by the companies in the S&P 500,”
Other studies back up this claim. A study by three finance professors published by Princeton University in 2002 looked at 101 years of market returns in the United States and Great Britain. It found that while capital gains determine year-to-year performance, long-term returns are mainly influenced by reinvested dividends.
A stock market portfolio during the study period that reinvested dividends grew 85 times larger than a similar portfolio that relied on capital gains alone.
Growth vs. dividends
Several studies have shown that stocks with high dividends have outperformed growth stocks with low dividends.
Jeremy Siegel of the Wharton School looked at the 500 S&P stocks and sorted them into groups based on dividends. He found that from 1957 to 2002 the group with the highest dividends had an average annual return of 14.3%, compared to 11.2% for the index as a whole and higher than a 9.5% return for the lowest-yielding group.
Another study by the equity research group at Lehman Brothers found that high dividend stocks produced more return with less risk than did low-yield stocks.
Some of the research indicates that high dividend yields correspond with those stocks classified as “value” stocks. Because their prices are depressed by various risk factors, value stocks tend to offer higher relative dividends.
A proliferation of investment research has indicated that value stocks outperform growth stocks over time.
A new tax advantage
Adding to the attractiveness of stock dividends is the relatively new tax advantage offered by federal tax reform in 2003.
Prior to 2003 dividends were taxed as ordinary income, with rates reaching as high as 35%.
Now qualified dividends paid by American companies are taxed at the same maximum rate offered on capital gains— 15%.