2008-03-13

Should You Reinvest Stock Dividends?

I figured I like dividends as much as the next guy or gal—the higher, the better, right? Well, some folks seem to like dividends a whole lot more than I do and seem to concentrate on them a whole lot more than I do. When I found these statistics in an article on The Motley Fool yesterday, I thought it might be time for a closer look:

Famed Wharton finance professor Jeremy Siegel . . . found . . . [f]rom 1871-2003, a full 97% of the stock market's return came from reinvested dividends. Only 3% was from capital gains on the original principal!

. . .

Ned Davis research found that from 1972 to 2006, S&P 500 stocks not paying a dividend returned 4.1% annually, while dividend payers returned 10.1%!


Now I have mixed feelings about The Motley Fool, driven mostly by what feels to me like pressure to sign up for their paid services every few seconds and a sometimes-sensationalist writing style—but I do find some of their articles make me think. Which for my little pea brain is a useful exercise.

When I first read the article, I read it too quickly and thought that the research was saying that 97% of stock returns came solely from dividends—which seemed crazy to me. When I read it again, I realized that the key word is reinvested. 97% of returns come from reinvested dividends.

While I didn’t know that number, this didn’t seem very earth-shattering to me. But when I looked through some blog and other discussions, there is more disagreement about whether to reinvest dividends than I had expected.

It seems to me that if you aren’t reinvesting dividends, you aren’t compounding your gains. It’s sort of like putting your money in an interest-bearing savings account—but pulling out the interest each month. Here’s an example starting with $100, bearing 6% interest (high for today’s savings accounts but low as a reference point against the stock market). The column on the left shows your result if you pull the gains out each month, and the column on the right shows compound gains.

Start

$100.00

$100.00

Yr 1

$106.00

$106.00

Yr 2

$112.00

$112.36

Yr 3

$118.00

$119.10

Yr 4

$124.00

$126.25

Yr 5

$130.00

$133.82

. . .

Yr 20

$220.00

$285.43

. . .

Yr 30

$280.00

$574.35

Now this is just a basic example of compounding. Most of the blog discussion and commentary I read on this issue was more complicated than that. Here’s a 2006 post at My Open Wallet (explaining why she doesn’t) and a follow-up post at Laws of Finance (saying it can be a personal decision). The positions the bloggers and commentary took against reinvesting dividends centered on whether the stock price would be good at the time of the reinvestment; and it mentioned strategies like pulling the dividends out and either putting them into a high-yield savings account or accumulating them until such time there was enough to make a new investment into some other stock or stock fund.

I’m not crazy about either of those. I’m worried about diminishing returns in the stock market going forward, but I think they’ll be better than savings accounts. I also don’t think I’m any good at timing the market on pricing anyway, so using the time of the dividend as a time to reinvest is likely to be good as anything else I’d do. On top of that, most dividend reinvestment plans don’t involve commissions or fees on the reinvestment. If you make a new investment, you may be incurring new commissions or trading fees. And for folks like us, we might not get back to putting the money back into the market as quickly as we intended—so reinvesting dividends is a way for us to stay in the market (if that’s what you want to do!).

Reinvesting dividends also compounds in two ways, relative to a savings account. As you accumulate more shares in the stock through reinvesting the dividends, you are gaining the dividend yield on more shares and the capital appreciation on more shares. Of course, it’s true that you may not ultimately end up with capital appreciation on all of the shares. That doesn’t bother me. We’d still be getting dividends on all of the shares, and we should hopefully be making capital appreciation on some of the shares. If the stock tanks so badly that it wipes out capital appreciation and most of the dividends, well, that’s part of the risk equation in stocks. At that point, I would think whether you reinvested dividends was not the big part of your loss!

In digging further, I found another article discussing Professor Siegel’s research on dividends—specifically, an example comparing IBM and Standard Oil between 1950 and 2003. During that period, IBM’s stock price increased by about 300 times—and Standard Oil’s by only about 120 times. But hypothetical shareholders in Standard Oil would have done much better—over 30% better. Why?

The performance differences comes from those seemingly paltry dividends: Despite the much better per share results of IBM, the shareholders who bought Standard Oil and reinvested their cash dividends would have over 15-times the number of shares they started with while IBM stockholders had only 3-times their original amount.
This example is more about the importance of dividends between stocks—rather than whether you should reinvest them (which was assumed). But it still shows the power of reinvesting—whether you end up with 3 or 15 times as many shares. And if it happened to be IBM or Standard Oil, you were doing well! (By the way, not everyone loves Siegel. The Wikipedia entry on him mentions Charlie Munger of Berkshire Hathaway called him “’demented’ for ‘comparing apples to elephants’ in making future predictions.”)

For some additional blog resources on dividends, I checked out the pfblogs.org listings. Four blogs have dividend as the beginning of their name: The Dividend Guy; Dividends 4 Life; The Div Guy; and Dividend Money.

I guess I’ll be doing some more reading and thinking on this—and ultimately on the importance of dividends in picking stocks or stock funds. In the meantime, we’re sticking with reinvesting dividends on all of our holdings. What are others doing?

4 comments:

Post a Comment

Comments are what make lots of blogs go 'round. Thank you for participating in this blog by adding a comment!

Also, my apologies. The comment spam coming into this blog has really been on the rise, and the word verification feature does not seem to be slowing it down very well. So for now, I am trying the addition of a registration (OpenID/Google/similar) requirement for leaving comments.

 

Original design by Linda of RS Designs.

Some hacks and functionality added by blog author with tips and code from
Blogger Buster, Hackosphere, and Blogger Accessories.