The Importance Of Dividend Reinvestment
Rupert is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
I often meet investors who do not understand the reasoning behind re-investing dividends, and I can see their point. I would rather have cash in the bank than be exposed in a stock. On the other hand, it is important to realize that re-invested dividends are actually one of the best methods to grow wealth with as little input as possible.
A very good example of the benefits of dividend reinvestment can be seen in the data from market crashes over the past 100 years – most importantly in 1929. In 1929 the S&P 500 reached an all-time high of 333.8--three years later it was down at 133. It took the market until 1956 to reach that high again. However, if dividends were reinvested throughout that whole time frame, an investor would have seen a return of nearly 100% over the same time period!
The same can be seen in the market from 2007 to 2012. The S&P 500 declined 22% over this period, but with dividends re-invested this decline was only 11%
So how does this look on an individual stock basis over a shorter time period?
Wal-Mart (NYSE: WMT)
Wal-Mart is no Google or Apple; in fact, the share price growth stinks. The 5-year period between year 10 (2002) and year 5 (2007) shows a total growth for the share price of -$1 or down -2%. However, over a longer 10-yr period, including re-invested dividends the stock returned 54.3%.
Although this is less than the S&P 500 return over the same period, Wal-Mart does have a Beta of 0.3, offering investors some security--effectively if the market suddenly plummeted 50%, Wal-Mart would only suffer around a 15% drop. In reality investors are receiving less share price growth for more share price stability.
ExxonMobil (NYSE: XOM)
On the other hand we have Exxon. Once again Exxon’s performance over the past 5-yr period is really, really bad: the stock has fallen just under 10%. Furthermore, over the past year the shares have hardly moved. This is where the dividend saves the day.
Exxon’s strong and reliable dividend has improved shareholder returns in both cases, giving investors a total return of 2.3% over a 1-year period and effectively ruling out the fall in the share price over the past 5 years.
Of course, over the longer period Exxon has really outperformed. The solid reliable dividend has almost doubled investors returns. Furthermore, over the ten year period just under 50% of the initial investment would have been paid back in dividends!
IBM (NYSE: IBM)
IBM provides another great view of the benefits of buying, holding, and re-investing. In fact, IBM provides the most consistent view. The stock has slowly ground higher over the past 10 years, constantly improving investor returns through a combination of good earnings and share buybacks.
IBM also issues a half decent dividend, which has helped spur investor returns. Just like Exxon, the share price of IBM has gone nowhere this year, but investors have been saved by the dividend.
How Has The Market Fared?
So how do these individual stock selections compare to the S&P 500 as an average? To find out, I looked at the closing prices of the S&P over the time periods, then I worked out the dividends paid on the index from the average dividend yield on the index in that year. However, this is not a true reflection of a direct investment in the index, as it would be unrealistic to envisage an investor buying every stock in the S&P 500.
So to produce a fairer result I have taken the total return and then deducted 0.75% to represent a management fee for a passively managed ETF or mutual fund.
The results are good. In most cases over the longer term the total return of all the stocks outperformed the S&P 500. Wal-Mart was outperformed by the index over a 10-yr term, but has offered a safe haven over the last five years. Exxon's 1 and 5-yr performances have been poor, but over ten years the stock's total return is around double the return on the index. IBM has outperformed on a 5-yr and 10-yr basis, but on a 1-yr basis the stock has underperformed.
Overall, a stock that offers a strong dividend can really improve an investor's performance if that dividend is re-invested. Re-invested dividends usually provide a better return than the market over time and defiantly smooth out any peaks or troughs that the market will may build for itself.
Some investors may not be able to re-invest dividends due to income requirements, but for investors with more cash to spare, compounding dividend re-investment is definitely one of the best investing strategies.
Sources: http://www.multpl.com, Yahoo! Finance
RupertHargreav has no position in any stocks mentioned. The Motley Fool owns shares of International Business Machines.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!