There is no other way of putting it; dividends are vital for creating long-term wealth. Shunning dividends and dividend stocks could be the greatest investment mistake you will make in your investment career. Even putting 25% of your net wealth into one high-risk over-the-counter stock that goes to zero would likely be less damaging to your financial standing over the long term.
The impact dividends will have on your portfolio is a long-term one. But compounding is a powerful thing and investing in dividends as soon as practically possible will certainly pay off over the long term.
Dividends are key to wealth creation
Tweedy, Browne’s booklet “The High Dividend Yield Return Advantage: An Examination of Empirical Data Associating Investment in High Dividend Yield Securities with Attractive Returns Over Long Measurement Periods” is a dividend investing bible. If you are looking for evidence as to how dividends can improve your investment returns, the book is almost certain to convince you that dividends are the most important part of investing.
The booklet is a collection of studies praising a dividend-focused investment strategy. The most revealing of these studies was first published in the highly informative “Triumph of the Optimists: 101 Years of Global Investment Returns,” written by Elroy Dimson, Paul Marsh and Mike Staunton.
Within the pages of the “Triumph of the Optimists,” the authors study the returns of numerous strategies over the years. The book is in no way limited to just dividend investing.
Nonetheless, there are dividend studies included, and the most informative one is a look at the respective contributions to returns provided by capital gains and dividends from 1900 to 2000. The study, conducted by the authors, discovered that while the year-to-date performance of equities was driven by capital appreciation, long-term returns were driven primarily by reinvested dividends. To reach this conclusion, the trio looked at the performance of two markets -- the U.S. and the U.K. -- from 1900 to 2000. Over the 101-year study period, they found that a market-orientated portfolio, which included reinvested dividends, would have generated nearly 85 times the wealth created by the same portfolio relying solely on capital gains.
The figures from the study showed if an investor started with one dollar invested in U.S. equities in 1990, by the year 2000 that dollar would be worth $198 in nominal terms. A capital gain of 5.4% per annum for 101 years. However, if that same dollar were invested in U.S. equities and dividends received were invested back into the market, by the end of the study the investor would be sitting on a total portfolio worth $16,797, a portfolio 85 times larger than that of the investor who decided not to reinvest dividends. The annual return on this portfolio would be 10.1%.
This study highlights a critical part of dividend investing. Dividends will fulfill their full potential only if they are reinvested back into the market, an argument which comes back to the fundamental principle of compounding.
Do not ignore compounding
Compounding is a highly valuable tool for investors, but only if used correctly. At the core of any strategy built on compounding is the desire to avoid losing money. When I say losing money, I do not mean avoid a 2% portfolio drawdown. I mean a permanent impairment of capital for a position. Permanent capital impairment usually comes from chasing higher returns, a lesson I learned all too well when I first started investing. I spotted a stock with an eye-catching 15% dividend yield, which it managed to pay for four quarters. Then in the space of seven days, it issued two profit warnings, declared management had been falsifying accounts, suspended its shares, and declared bankruptcy. Luckily, I understood the need for diversification in any portfolio, and I lived to invest another day.
Still, this experience taught me a valuable lesson: investing is not about chasing returns. It is about protecting your capital and making sure it is invested with the best business managers who have a record of achieving results for shareholders.
”‹Disclosure:Â The author owns no stock mentioned within this article.
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