How do dividends drive your returns in the stock market?

The reader asks:

Should most investors reinvest their dividends – why or why not? My initial thought is while I’m still accumulating assets, yes, but when withdrawing in retirement, take the dividend as cash. I’ve read the stats that say a large percentage of compound returns come from reinventing the dividend so it seems like a good move and another way to dollar cost averaging on a smaller scale but maybe I’m missing something.

This is a question that seems basic on the surface but one that many investors probably don’t give much thought to.

Let’s take a look at the history of stock market returns to show how important dividends are to performance over time.

Here is a chart of the S&P 500 from 1928 through 2022 based on price:

This is the indicator without taking into account the reinvestment of dividends.

The price index has gone from just under 18 in 1928 to over 3,800 by the end of 2022. That’s good enough for a total return of over 21,500%, or 5.8% annually.

Very good isn’t it?

What if we factor in reinvested dividends for the total return number?

This brings us from 5.8% annually to 9.9% annually over the 95 years of data.

And so that’s 70% higher when you reinvest cash flows into the market. Does this mean that total returns will be 70% higher as well?

No, it’s much better than that because compound interest works exponentially rather than linearly. The total returns are much higher.

With the reinvestment of profits, the total return increases from 21,500% with an annual return of 5.8% to over 750,000% with a return of 9.9%.

The total return is about 35 times higher than the price return alone. So one dollar invested in the US stock market in 1928 in price returns would have been about $216 by the end of 2022. With the dividend reinvested, we’re now talking more like $7,500.

And it should be noted – this doesn’t take into account things like taxes or fees or the fact that it was basically impossible to reinvest your earnings very easily until recent decades.

But this represents a nice uptick in terminal value through the dividend.

Does this mean that profits are the main source of revenue?

not nessacary.

Part of this is the fact that even a small increase in returns can lead to massive amounts of complexity over a 95-year period. Obviously, most of us don’t have the luxury of having a 95-year time horizon.

But even during more realistic time horizons, dividend reinvestment can play a huge role in stimulating your returns. I have about 95 years of stock market returns to look at which is good enough for three non-overlapping 30-year periods.

Most investors will have a 30-year time horizon if they’re saving for retirement (some retirees will have that time, too).

Below is a comparison of three separate 30-year periods for the US stock market along with corresponding price returns, total returns, and growth of an initial $10,000 investment.1

The improvement from price to total returns anywhere from 2-3x was better for the growth of that initial $10k investment.

So dividends can have a significant impact on your results in the long run if you reinvest them seriously for the long term.

Now, for retirees, it might make more sense to use dividend or bond income in your pulling strategy. You can also be flexible in terms of when you reinvest it or spend it depending on the market environment.

The point here is not that dividends are a magical source of revenue. They are not.

The point is that even slight margins that accumulate over a decade of timeframes can add a lot of value to your portfolio. These slight edges can come from:

  • Invest on a regular basis regardless of the market environment.
  • Keep your fees to a minimum.
  • Maintain a low turnover rate.
  • Being aware of the taxes in your portfolio.

Applying a sensible investment approach that consistently gives you various sources of small margins and allowing them to accumulate over time can produce extraordinary results over decades long timeframes.

I know it’s hard to wrap your head around the idea of ​​investing for 10, 20, 30 years or more but this is where the real money is made.

Overlay is a really nice thing as long as you get out of your way and let it work for you.

We touched on this question for the latest version of Portfolio Rescue:

Bill Artzronian Join me on this week’s show to discuss questions about putting cash to work in the markets, when to buy a new home in a new city, changes in tax code and retirement contributions for 2023, tax changes for when you get married and when to rent as a CPA.

Further reading:
The best source of investment income?

Here is the podcast version:

1I don’t know when we all agreed that $10,000 was the number but that’s the number we’ve all come to.

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