The reinvestment of dividends is essential to building wealth. Only spend your dividends in retirement.
Investors building their wealth usually depend on stocks. Many studies have shown that stocks outperform bonds and cash over long periods of time.
The Sunday Times, however, writes that this outcome “relies on one big assumption—that all dividends paid by the companies are reinvested. If you strip out these payouts, cash has been more likely to beat shares over any 18-year period since 1899, when Queen Victoria was still on the throne.”
The British newspaper based its conclusion on Barclays’ Equity Gilt Study. (Gilts are government bonds in Britain.) This study examines the returns on stocks and cash, among other assets. Barclays found that stocks beat cash 99 per cent of the time when dividends were reinvested in the shares of the companies that paid them. Without such reinvestment, stocks won only 40 per cent of the time.
Compound interest make a big difference
Sree Kochugovindan is an asset allocation strategist at Barclays. The Sunday Times quotes him as saying: “Dividend reinvestment can make a huge contribution towards your final returns, especially if you plan to hold your investment over the long term.” That’s due to compound interest, which Albert Einstein called one of the wonders of the world.
Tom Stevenson, an investment director at Fidelity International, concurs. According to The Sunday Times, he said: “Thanks to the wonderful power of compound growth, reinvesting your income year in, year out can supercharge your returns.”
Consider the following example from Barclays’ Equity Gilt Study. An investment of £100 in 1899 would be worth £177 in 2016—over and above inflation. Reinvest the dividends, however, and that £100 would be worth £28,232 over and above inflation.
These results are based on Britain’s experience. Results in Canada and the United States are similar. We point this out in our twice-a-year report on DRIPs (Dividend Re-Investment Plans). In fact, the powerful positive results from reinvesting dividends is one reason why we publish the DRIP reports.
We stress, however, that dividend reinvestment is vital only in building your wealth. Once your wealth is built, then you should spend the dividends to support your lifestyle.
Keep in mind, too, that companies that regularly raise their dividends are even better. They’re likely to increase in value even if you spend all of your dividends. That’s because if the share price stays the same, the dividend yield will advance year after year. Eventually, that yield simply becomes too high to ignore. At that point income-seeking investors will bid up the prices of your shares.
Growing dividends pay off
Interest rates are very low these days, of course. As a result, more retirees have turned to dividend-paying stocks to raise their incomes. We hear warnings that when interest rates rise, dividend-paying stocks will fall.
These warnings look overdone for four reasons. First, retirees can focus on ‘dividend aristocrats’ (companies that have raised their dividends for at least five years in a row). Rising dividends can pay you more than interest, even if interest rates were to soon recover. Consider BCE Inc. (TSX—BCE). Its dividend of $3.50 a share yields 5.6 per cent. This will rise every time that it raises its dividend. Bonds never pay more than promised.
Second, dividends benefit from the dividend tax credit. Interest, by contrast, is fully taxed outside of tax-deferred accounts. Third, growing dividends let you beat inflation.
Fourth, interest rates have remained low ever since the financial crisis of 2008—thirteen years ago. US multinational companies have suffered from a high US dollar. If the US central bank raises rates, the multinationals’ pain will likely increase. Most central banks have reduced their rates. In fact, some now charge commercial banks for the ‘privilege’ of depositing money with them. So interest rates worldwide look unlikely to jump in the near future.
This is an edited version of an article that was originally published for subscribers in the August 13, 2021, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.
The Investment Reporter, MPL Communications Inc.
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