How Dividends Work, Add to Stock Returns: Chief Investment Strategist
It’s been a volatile and difficult year for investors in the broader stock market, and tech stock investors have had it even worse. If you invest in dividend-paying stocks, however, you’re probably doing a little better.
There’s a good reason for that, says Sam Stovall, chief investment strategist at CFRA Research. “Dividend stocks reduce your overall volatility,” he says. “Dividend payments provide a cushion to offset price declines.”
Case in point: The S&P 500, a benchmark for the broader stock market, is down about 16% so far in 2022. An index that tracks S&P 500 technology stocks is down about 23% on the year and remains firmly anchored in the bear market. territory – defined as a decline of 20% or more from recent highs.
The FTSE High Dividend Yield Index, which tracks the performance of large and medium-sized companies that pay the highest dividends relative to their stock prices, was down just over 5% on the year.
But dividend stocks aren’t just useful when the going gets tough. Stovall notes that since 1945, reinvested dividends have contributed 33% of the total return of the S&P 500.
“Essentially, dividends can boost your performance by a third for nothing,” he says. “You can add octane to your performance simply by owning stocks that pay dividends.”
Why Dividends Boost Stock Returns
Even if you didn’t know it, you probably already own some dividend-paying stocks. Some 400 stocks of the S&P 500 pay one.
Here’s how it works. When a business makes excess profits, it has a number of choices about how to use the money. It could reinvest in the business, for example by opening new stores or funding research into new product lines.
But many companies – especially large and financially mature ones – choose to redistribute some of that money to shareholders as a sort of “Thank you, please stick around.” These regular cash payments constitute a stock dividend.
Investors also have a choice when it comes to dividends. If you are a retiree, you could take this cash payment and use it as pocket money. For young, long-term investors, the common approach is to reinvest the dividend in your portfolio.
To understand how this can improve your investment performance, calculate a stock’s dividend yield by dividing the amount of cash you receive annually from a single stock by the stock’s price. If you own a stock that is worth $50 per share and you get $1 for every stock you own, that stock earns 2%.
By adding this dividend yield to a stock’s price return (the percentage up or down in the stock price), you can find the total return you get from an investment. If your stock goes up 10% and earns 2%, you have earned a 12% return on your investment.
If the same stock drops 5%, that 2% payout brings your total return to 3%.
Stovall’s 33% figure represents the difference between the price return of the S&P 500 and its total return since 1945. pricing, according to FactSet Data, which means a $10,000 investment would now be worth $155,500.
Add in reinvested dividends and you can see the power of compound interest on extra cash. Taking into account the total return, $10,000 would now be worth $329,300. This means that dividends accounted for 68% of the total return of the broader market during this period.
How to add dividends to your portfolio
If you’re not already reinvesting dividends into your portfolio, you can set up automated reinvestment through just about any online brokerage account. If you own a fund that tracks the S&P 500, you increase your return with the overall index return of 1.6%.
If you want to further increase the yield of your stock portfolio, you can invest in one of the many mutual funds and exchange-traded funds that focus on dividend payers. These generally come in two forms: funds that focus on high-yielding stocks and strategies that invest in companies that continually increase their payouts.
The former is better suited to investors looking for a bit of ballast in a choppy market, says Todd Rosenbluth, head of research at investment analytics firm VettaFi: “Companies that pay returns above the average tend to hold up better when the markets are selling off. The yield gives you that downside protection.”
For those looking to maximize their long-term returns, funds that find dividend producers are better suited.
“A company only increases its dividend if management has confidence in the company’s long-term prospects,” Rosenbluth says. “These actions will have more chance [than higher yielders] to follow the larger market, while offering higher incomes than the larger market. »
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