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In principle, making money in the market is all about buying low and selling high. At least that’s what most people tend to think, and a great deal of effort goes into trying to identify stocks with the best growth potential. However, while capital gains are indeed a fundamental aspect of building wealth in the market, they represent only half the story, literally. Numerous studies have shown that over the long term, close to half of the total return from stocks comes from dividends. This alone suggests that investors would be foolish to ignore the humble dividend, but there are a variety of other compelling reasons as to why even the most aggressive of growth investors should consider the income potential of stocks.
Even a cursory glance at the market will tell you that it is a volatile place. To many it is this very fact that makes the market so appealing; after all, sudden and significant changes give the potential for attractive short term gains for those of a speculative bent.
For those of us more concerned with investing though, this volatility represents a significant risk. If you hold only growth stocks that have never paid a dividend, and need to liquidate your holdings, the return you receive will be very sensitive to the mood of the market at the time. People who were planning on retiring recently know this only too well.
No one can predict when the next crash will hit or how significant the correction will be, so understand that if your strategy is completely focused on chasing capital gains you better ensure you are able to leave your investments untouched for many years.
But while a long term view will allow you to ride out any negativity, you don't receive any benefit whatsoever in the interim, absolutely none. You will only ever realise a gain when you sell, and again that gain will depend largely on market sentiment at the time.
Now consider the case with income investors who look to generate part of their return through dividends. It’s certainly true that dividends have also been impacted by the GFC, but the decline here was substantially less than was the case with share prices. Moreover, dividends have proven to be extremely consistent over the long term. Whereas share prices tend to bounce all over the place, dividends tend to be significantly less volatile.
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As you can see, BHP Billiton’s share price has (like all stocks) had a bumpy ride over the years. But its dividends have been remarkably steady, virtually never going backwards even over the recent market difficulty. They could well drop a little in 2010, but I bet they don't experience the kind of declines experienced by the share price.
It’s a fair criticism to say that you can justify almost any argument with a selective use of stocks, so let’s look at a much wider sample: the ASX200 index. As you can see below, dividend income likewise dropped on average last year. However here we see a decline roughly half that experienced by share prices. Moreover, you can again see how dividend income has been remarkably stable over the years.
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In either event, the GFC wasn’t kind to investors. But the point is that while growth investors’ capital was devastated and may take years to recover, the income investor experienced a temporary pay cut, and a relatively modest one at that. Retirement plans were not destroyed, and investors were able to leave their capital untouched and exposed to any subsequent recovery.
Of course capital gains are still important to the income investor. But the fact is that over time, rising dividends translate to higher share prices. Which makes sense; with all else being equal a rational investor should be willing to pay more for an asset that has a higher income potential. And indeed this is what we observe in the market. You will not find a stock that has steadily increased its dividends over time that has not also increased in value, despite the occasional short term perturbation.
Another important point to make is that income investing is equally valid for those who are a long way from retirement. Modern financial wisdom states that young investors should favour growth, and I certainly agree with that, but you can easily turn dividends into shares via reinvestment. This not only means you essentially get paid in extra shares each year, but those new shares will pay a dividend next year, which will buy you more shares, which will pay you more dividends, which will buy you more shares...so on and so forth. Thus the awesome power of compounding is unleashed.
This is most elegantly demonstrated by comparing the All Ordinaries index with the All Ordinaries Accumulation index (which reinvests dividends when they are paid).
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The scenario under which dividends were not invested saw a total income return of $590,979 and a capital gain of $847,511 giving a total return of $1,438,490 or 1438% on the initial investment of $100,000. And let’s face it, that’s quite impressive and in itself demonstrates the value of long term investing.
However the reinvestment scenario saw capital grow to a substantial $3,257,693, which is more than double the return we received under the first scenario (126% extra in fact), and represents a total return of 3258% on the initial investment. Put simply, dividend reinvestment and the resulting effects of compounding will give you substantially enhanced growth prospects over the long term.
The other point to make here is that this example covers a period in which we saw a number of significant economic recessions and bear markets. Yet the relentless rise of dividends continued, with scarcely any volatility at all.
A focus on capital gains alone is really putting the cart before the horse. Dividends and their potential for growth are far more important, and besides will ultimately deliver capital gains anyway.
The main points to remember:
- Dividends are on average very dependable and will tend to grow over time
- Dividend returns are less susceptible to market downturns
- Capital gains can only ever be accessed by selling, whereas dividend returns are received like clockwork without having to touch your capital
- Income can be converted to growth via dividend reinvestment. Moreover the growth will be exponential in nature over the long term
- Income returns significantly enhance total return
- An income strategy is low maintenance and requires little effort
Make the markets work for you
Andrew Page
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