Dividends on dividends

Last week, some readers expressed surprise that stocks, as represented by the Dow Jones Industrial Average, had outperformed gold over the last 40 years. In that timeframe gold is up 45x while the Dow rose from 888 to 12,600 – a 14x return.  Nice, but not the 53x we attributed to the Dow. What gives?

The answer is a great object lesson in dividend reinvestment.

Price and yield

Let’s start with the basics. Total return includes two components: price appreciation and yield. With no yield, gold’s return comes completely from price appreciation. From late July 1971 to late July 2011 that price rose from $35 to $1600 per ounce, a smooth 45x gain, or 9.5 percent annualized return.

The 53x return for the Dow is a 10 percent annualized return. Approximately 6.6 percent came from price appreciation. The rest came from dividend yield.

The average yield of the Dow over the last 40 years has been 3.4 percent.  (The yield curve is anything but a straight line. Dividends peaked in mid-1982 at 8.6 percent yield, more that six times the 1.3 percent rate in 1999. The current yield is 2.5 percent. See historic Dow yield chart from Barrons, the blue line, below.)

(click on image to enlarge)

It’s a triple

By holding the Dow and reinvesting dividends quarter after quarter for four decades, a hypothetical investor more than tripled his total return from 14x to 53x.

We often refer to taxes, inflation and fees as the silent killers of portfolio return, quietly eroding value.  By that standard, we should call dividends the silent health and wellness program of portfolio returns, boosting value even when prices flounder.

Yields of several percent generally sound pretty modest relative to stock prices that can shoot up 20-30 percent in a year. But they compound neatly, regardless of price fluctuations. Even when stock prices decline, dividends typically continue. And many companies take pride in continually increasing dividends year after year, regardless of short-term swings in stock price.

The ultimate impact of dividend reinvestment, of course, is more shares, all earning dividends. Dividends on dividends. Ignoring changes in the composition of the index and stock splits, an investor who bought one share of each stock in the Dow forty years ago might have three times as many shares today, all paying dividends every ninety days.

Focus on the long term

Since last week’s post the Dow and all other stock indices are down several percent on plenty of gloomy reports about the economy. This forty-year analysis of price and yield is a good reminder that 1) what really matters is long range total return, not what happens yesterday or tomorrow and 2) dividends have a far greater impact than most investors perceive.

Let the compounding continue.

This article may include forward-looking statements. All statements other than statements of historical fact are forward-looking statements (including words such as “believe,” “estimate,” “anticipate,” “may,” “will,” “should,” and “expect”). Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to be correct. Various factors could cause actual results or performance to differ materially from those discussed in such forward-looking statements.

Nothing in this article is intended to be or should be construed as individualized investment advice. All content is of a general nature. Individual investors should consult their investment adviser, accountant, and/or attorney for specifically tailored advice.

Any references to third-party data or opinions are listed for informational purposes only and have not been verified for accuracy by the Adviser. Adviser does not endorse the statements, services or performance of any third-party vendor without specifically assessing the suitability of a third-party to a client’s or a prospective client’s needs and objectives.

Returns are based on data from July 25, 1971 to July 25, 2011.

An investment cannot be made directly in an index. Returns for Dow Industrials do not reflect transaction costs.

Past performance is not an indicator of future results.

There is no guarantee that any company will continue to pay dividends to investors.  Dividend payouts can be reduced or eliminated by any company.