Investing

The Benefit of Reinvesting Your Dividends

Stacy Rapacon

What a difference a dividend makes.

Often, when we talk about how the market or even a single stock is performing, we point to the change in price—but calculating returns isn’t always so simple. When a company pays a dividend, you should factor that in, too. For a fund or index made up of hundreds of different stocks, you should include dividends from all the companies that pay them. That can dramatically alter returns.

For example, from December 2006 through December 2016, Standard & Poor’s 500-stock index (a benchmark often used to represent the overall market) gained a total 58.6 percent, or an average 4.7 percent a year. Not bad, considering the time period includes the Great Recession. Even better? If you count reinvested dividends, returns rose to 95.7 percent, or an average of 6.9 percent. (Neither calculation adjusts for inflation—that’s a different story.)

Not impressed by a two-point difference? Let’s talk dollars. If you invest $1,000 and get an average 4.7 percent return, you’d have $1,583 after 10 years. With an annual 6.9 percent return, you’d net $1,949. So for literally zero additional effort, you’d make an additional $366.

Remind me: What are dividends, again?

Companies have been paying dividends for about as long as they’ve been issuing stocks, starting with the first publically traded company, the United East India Company. The periodic payouts give certain shareholders an extra cut of company earnings—like a little bonus alongside returns on shares.

Why would companies do that?

To attract investors like you. Plenty of people appreciate a little cash in hand to help dampen the risk of relying on returns. Even if prices are going down, a company may continue paying out dividends.

Take General Electric, for example. Back in June 2007, its price was around $38, but has since dropped to around $27—or nearly 29 percent lower. Ouch. However, the company continued to pay dividends throughout the past decade, though it did cut its annual dividend a couple of times, from $1.24 in 2008 to $0.82 in 2009 and then to $0.42 in 2010 (after regularly upping dividends for years before).

The small payout helped take the sting out of the company’s losses and actually resulted in a slight gain for investors. The adjusted stock price, which accounts for dividends (as well as stock splits), was about $26.60 at the end of June 2007. So if you’d invested $1,000 in GE then, you’d have about $1,160 at the end of June 2017.

Why do they make such a big difference in returns?

The trick is in reinvesting. Automatically putting the payout back into the stock forces you to keep adding to your investment, and mimics the advantages of dollar-cost averaging: You’re buying more shares when the stock price is low and fewer shares when it’s high, which may help maximize your gains.

So should I only invest in dividend-paying stocks?

Some people do, but it probably shouldn’t be your only strategy. For one, wealth manager Carlos Dias Jr. points out, “there’s absolutely no guarantee a company will pay a dividend.”

Plus, if you only invest in dividend-paying stocks, you’re not diversifying well. Most companies that pay dividends tend to be bigger, stable institutions that can afford to share the wealth. Typically, they’re not expecting any of the heady growth you might find with a smaller or newer company, so you may be trading bigger future returns for current dividends. Also, paying dividends is more common in certain sectors, like utilities and telecomms. Focusing on those companies may lead you to pile too much of your portfolio into the same category.

And remember, proper diversification is key for investing success. “For a good quality diversified portfolio, you can’t just have one strategy that’s diversified,” says wealth advisor Bradford Pine. “You need many strategies with different components that will perform differently in different markets.”

Still, having some dividend-paying stocks in your portfolio can give you a nice boost. “It’s like a little icing on the cake,” Dias says.

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