How dividends work, add to stock returns: chief investment strategist

It’s been a volatile and difficult year for investors in the broad stock market, and tech-stock investors have had it even worse. If you invest in dividend stocks, however, you’re probably doing somewhat 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 offer a cushion to offset price declines.”Case in point: The S&P 500, a yardstick from the broad stock market, is down about 16% so far in 2022. An index tracking technology stocks in the S&P 500 is down about 23% on the year and still sits solidly in bear market territory — defined as a decline of 20% or more from recent highs.The FTSE High Dividend Yield Index, which tracks the return of large- and medium-sized companies that pay the highest dividends compared to their share prices, is down just over 5% on the year.But dividend stocks aren’t just handy when the going gets tough. Stovall notes that since 1945, reinvested dividends have contributed 33% of the total return in the S&P 500.”Essentially, dividends can improve your performance by a third without doing anything,” he says. “You can add octane to your performance just by owning dividend-paying stocks.”Why dividends boost stock returnsEven if you didn’t know it, you likely already own some dividend-paying stocks. Some 400 stocks in the S&P 500 pay one.Here’s how it works. When a company earns excess profits, it has a number of choices for how to use the money. It might reinvest in the business, say, by opening new stores or funding research into new product lines.But many companies — especially large, financially mature ones — choose to distribute some of that money back to shareholders as a sort of “Thank you, please stick around.” These regular cash payouts are a stock’s dividend.Investors have a choice when it comes to dividends, too. If you’re a retiree, you might take that cash payment and using it as spending money. For younger, long-term investors, the common move is to reinvest the dividend back in your portfolio.To understand how that can boost your investment performance, calculate a stock’s dividend yield by dividing the amount of cash you receive annually from a single share of stock into the share price. If you own a stock that’s worth $50 per share and you get $1 for every share you own, that stock yields 2%.By adding this dividend yield to a stock’s price return – the percentage it moves up or down in share price – you can find the total return you earn from an investment. If your stock goes up 10% and yields 2%, you’ve earned a return of 12% on your investment.If the same stock declines by 5%, that 2% payout brings your total return up to 3%.Stovall’s 33% number represents the difference between the S&P 500’s price return and its total return since 1945. In more recent years, the difference has been more stark: Since 1988, the S&P 500 has moved up a cumulative 1,455% in price, according to FactSet data, meaning a $10,000 investment would now be worth $155,500.Add in reinvested dividends, and you can see the power of compounding interest on the extra cash take hold. Factoring in total return, a $10,000 would now be worth $329,300. That means dividends accounted for a whopping 68% of the broad market’s total return over that period.How to add dividends to your portfolioIf you’re not already reinvesting the dividends in 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’re boosting your return by the index’s aggregate yield of 1.6%.If you want to increase your stock portfolio’s yield more, you can invest in one of many mutual funds and exchange-traded funds that focus on dividend payers. These generally come in two flavors: funds that focus on stocks with high yields, and strategies that invest in companies that continually raise their payouts.The former is better suited to investors looking for some ballast in a choppy market, says Todd Rosenbluth, head of research at investing analytics firm VettaFi: “Companies that pay above-average yields tend to hold up better when markets sell off. Yield offers you that downside protection.”For those looking to juice their long-term returns, funds that find dividend growers are a better fit.”A company is only raising its dividend if management has confidence in the firm’s long-term prospects,” Rosenbluth says. “These stocks will have a greater chance [than higher yielders] of keeping up with the broader market, but still offer higher income than the broader market.”Sign up now: Get smarter about your money and career with our weekly newsletterDon’t miss: Want to retire early? Answer 1 question first, says financial planner

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