You Won't Match the Market Unless You DRIP

A dividend reinvestment plan is the key to achieving the best possible returns from the market

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Jan 30, 2017
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There is plenty of evidence that shows that dividends are critical to driving equity portfolio outperformance over the long term, but how you invest your dividends has a lot to with the excess returns generated.

In the world of low-cost discount brokerage, reinvesting your dividends has never been easier. Many online brokers offer low-cost dividend reinvestment plans, which means you can literally set to buy and forget. The bonus here is that you do not need to monitor your dividend reinvesting and the automated program will continue to invest dividends no matter what the market environment.

Investing no matter the market environment is another key part of improving returns. All investors know the mantra buy low and sell high, but in practice few follow this. At the bottom of the market, it's hard for many investors to commit extra capital; instead, they withdraw, which has led to the alternative mantra buy high and sell low.

Don't try to beat the market

Trying to time the market can be hugely detrimental to your long-term investment returns. The problem is the average investor just can’t predict the market with any degree of accuracy. For example, between 1993 and 2013 the Standard & Poor's 500 achieved a compound annual growth rate of 9.22%, but if you missed the top five trading days, the CAGR would have dropped to 7%. Miss the top 20 trading days, and the CAGR drops to 3.02%. If you missed the top 40 days, the return over the period would be -1.02%.

Accelerate the returns

Buying when the market is depressed by automatically reinvesting your dividends means there is no requirement for additional capital. When the market eventually recovers your returns will be turbocharged thanks to the additional equity holdings and lower all-in purchase price. The best way to demonstrate the benefits of a DRIP plan is with numbers.

According to Simply Safe Dividends, which cites data since 1871 from Moneychimp.com, the S&P 500 has produced a compound return of 460x or 23.32x adjusted for inflation. The CAGR in percentage terms is 4.32% since 1871 or 2.23% adjusted for inflation. These returns are pretty abysmal, and it’s more than likely that you could have achieved a higher return on your money with other endeavors.

If you insert dividends in the calculation the returns change completely. In fact, the returns are so different when you include dividends reinvested it begs the question of why investors sometimes ignore this key strategy.

Since 1871 with dividends included the S&P 500 has risen 285,463x. Adjusted for inflation this return is a lower 15,087x. On a CAGR percentage basis, the index has gained 9.05% per annum with dividends reinvested during this period. Adjusted for inflation the annual return is a couple of hundred basis points lower but still three times higher than the no-dividend reinvestment index performance.

Adjusted for inflation with dividends reinvested the S&P 500 has produced a CAGR of 6.86%.

There are plenty of other studies that produce a similar result. In the “Triumph of the Optimists: 101 Years of Global Investment Returns,” written by Elroy Dimson, Paul Marsh and Mike Staunton, the authors study 100 years of data across the U.S. and U.K. markets from 1900 to 2000.

The study shows that if an investor started with $1 invested in U.S. equities in 1990, by the year 2000 that dollar would be worth $198 in nominal terms –Â a capital gain of 5.4% per annum for 101 years. On the other hand, 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%.

All in all, dividend reinvesting is the key to wealth creation. Ignore it at your peril.

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