How Important Are Dividends?

The Importance of Dividends for Investors: Why You Should Reinvest Them

Our goal as an investor is to design a portfolio that can ultimately create an income stream for us during retirement.

I’ve touched on this idea before both here and here.

I believe many investors don’t understand the importance of dividends and how they can become a game-changer in driving your portfolio’s growth.

As a reminder, dividends are cash payments distributed by corporations to their shareholders.

When a company consistently pays out a dividend, and tends to increase it over time, that signals a company with strong fundamentals, particularly cash flow, and a robust management team who wants to reward shareholders.

S&P 500 companies have a long history of paying a dividend, which has historically run considerably above inflation, helping you preserve your purchasing power:

Even during major market sell offs, like from 2000 - 2002 and 2007 - 2009, the dividends paid out by by S&P 500 companies did decrease, but not by nearly as much as the markets declined.

This signals the resilience of dividends and that even during major declines, companies have the ability to maintain and even increase their dividends over time.

Not to mention that the ‘payout ratio’ is at historically low levels which indicates that these companies will continue to pay and increase dividends over time:

Despite record high dividend payments, the companies that comprise the Index are paying out a smaller portion of total earnings in the form of dividends than average. From our perspective, companies are more likely to increase or keep dividend distributions steady if earnings are growing.

Maybe you only have $10,000 invested in the S&P 500 and you aren’t impressed with the ~$36 quarterly dividend hitting your account.

But money adds up and with the power of compounding, it starts off gradually, and then suddenly.

These dividends can significantly increase your total returns over time:

Dividends have played a significant role in the returns investors have received during the last several decades. Going back to 1960, 85% of the cumulative total return of the S&P 500 Index can be attributed to reinvested dividends and the power of compounding as illustrated in FIGURE 1 (31% on an average annual basis).

You should be reinvesting these dividends, rather than have them pay to cash.

When you reinvest your dividends, you purchase additional shares of stock or an index fund, which in turn generates more dividends.

We welcome the temporary market declines, as our plan continues to work through dividend reinvestment which allows us to buy more shares at even lower prices...

But it’s not just dividends or die, and you should never chase yield.

AT&T is currently paying a dividend yield of close to 6%.

Sounds enticing doesn’t it?

Until you look at a 5-year chart of the stock:

We still need “growth” companies in the portfolio. These types of companies typically don’t pay a dividend, as they are reinvesting all profits back into the business to fuel more growth.

You are rewarded owning these names when the valuation of the company increases (hopefully).

Some people still view “dividend stocks” as boring or that they only relate to mature industries with slowing growth.

Think Altria Group, AT&T, Verizon, Walgreens, etc.

But as Capital Group points out:

…dividends are gaining favor among information technology giants. Meta, Alphabet and Salesforce all introduced dividends in the first half of 2024, and those announcements appear to be shifting the narrative.

Meta and Alphabet’s dividends can be viewed as a signal of capital discipline among tech innovators and a commitment to shareholder returns. Tech companies accounted for 14.1% of total cash dividends paid by S&P 500 companies in 2023, making them the second largest contributor by sector in dollar terms.

Dividends are more than just a source of income; they are a powerful tool for building your wealth over the long term.

Reinvesting the dividends throws gasoline on the compounding fire.

Double check your investment accounts or your IRAs, are your dividends being reinvested?

Disclosure: This material is for general information only and is not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.

All indices are unmanaged and may not be invested into directly.

All investing includes risks, including fluctuating prices and loss of principal.