By David J. Marshall, CFA
The historically low interest rates of recent years have created a dilemma for income-oriented investors. Where should they put their money when yields on traditional fixed income investments like money market funds, corporate bonds, U.S. Treasury securities and bank CDs have essentially been next to nothing?
For many investors, stocks have proven to be a surprisingly viable alternative, but not just any stocks—stocks that pay dividends and offer the promise of being able to increase those dividends over time. The importance of dividends has often been overlooked; but going forward, baby boomers needing income as they peer into retirement will demand dividend-oriented investments.
The first company to pay a dividend on its stock was the Dutch East India Company in the 1600s. Several American companies like Procter & Gamble and DuPont have been paying dividends for more than 100 years. And since 1926, dividends have accounted for more than 50% of total market return. In fact, a recent article in Forbes cited a Wharton School study that examined U.S. stock performance throughout history until the early 1990s. The study found that approximately
75% of total return on all U.S. stocks during that time was attributable to dividend reinvestment and compounding, while only 25% was due to capital gains.
And yet, many investors don’t consider dividends when determining how to structure their portfolios. They somehow perceive dividend stocks as stodgy and old fashioned—their father’s (or even grandfather’s) investment that lacks the excitement and growth potential of smaller companies poised to benefit from
bullish market conditions.
It’s important to remember, however, that dividend stocks offer a number of benefits that their non-dividend counterparts do not:
They Generate Income:
Dividend stocks typically offer yields that range from 1.5%-5% or thereabouts. Unlike interest from bonds, dividends are not an obligation of the company that distributes them. Dividends come from cash flow, and as a result they can be suspended during periods when companies experience difficult business conditions. That said, many companies have maintained or even increased their dividends over time. Investors can use dividends to help meet day-to-day retirement expenses or to purchase more shares of the underlying stock, which brings us to our next benefit.
They Offer Potential Appreciation & the Ability to Compound Returns:
Like any stock, dividend stocks are subject to price fluctuations that may result in gains or losses for investors. Unlike other stocks, however, dividend stocks often offer dividend reinvestment plans in which dividends are automatically used to purchase additional shares and fractional shares. Over time, this can make a substantial contribution to total return. To give you an idea how substantial, consider that a $10,000 investment in the Standard & Poor’s 500 at its inception in 1926 would have grown to $33.1 million by the end of 2007. If dividends had not been reinvested, the investment would have grown to only slightly over $1.2 million.
They Help Cushion Volatility:
With non-dividend stocks, you can only make money if the prices of those stocks rise. With dividend stocks, you can make money through dividend payments, even if the prices of your stocks remain flat or decline. What’s more, declining stock prices increase the yields of dividend stocks, thereby making them more attractive to income-oriented investors. As a result, dividend stocks offer a degree of protection in declining markets and have therefore proven popular with conservative investors seeking preservation of capital.
The flip side of this benefit is that dividend stocks tend not to rise in price as dramatically as non-dividend stocks in bullish markets. Companies that don’t pay dividends reinvest profits in an attempt to grow their businesses. Those that succeed are often rewarded more by the market than companies that distribute a portion of their profits to shareholders.
Still, dividend stocks have outperformed the overall market over the long term. For the five year period ending May 29, 2015, the S&P Dividend Aristocrat Index, which consists of companies that have consistently increased their dividends every year for at least 25 years, provided a return of 18.05% versus 16.54% for the S&P 500. For the 10 year period ending on that date, the Dividend Aristocrat Index again outpaced the S&P 500 by 10.72% to 8.12%.
Maybe Father Knew Best After All
What all this means to investors is that your father’s favorite investment still warrants consideration in today’s market environment—in fact, especially in today’s market environment. Dividend stocks may have lagged their non-dividend counterparts in the bull markets of the 1980s and 1990s, but in more normal markets, they have tended to excel. If you believe that the current market will generate more modest returns than in recent years, you might consider the value of adding dividend stocks to your portfolio. Furthermore, stocks of companies that have demonstrated an ability to increase their dividends consistently may prove especially attractive.
DISCLAIMER: This column is for informational purposes and should not be considered personalized investment advice. Everyone’s circumstance is different, and individuals should seek investment advice based on their unique financial situation. All investments are subject to risk, including loss of principal.