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Are Dividends More Important Than Price Appreciation?

“I’ve read that dividends account for the vast majority of the return of the stock market over history. I’m confused by the article you linked to last week about not being a dividend investor, given that dividends are so much more powerful than price growth.”

It’s true that, without dividends, you’d experience only a small portion of the market’s overall return over an extended period. But the idea that dividends are more powerful than price appreciation is a significant misunderstanding. (Unfortunately, I’ve seen this misunderstanding intentionally encouraged in the effort to sell products — dividend investing books, newsletters, etc.)

To explain, let’s look at an example of compound growth.

• \$1,000 compounded at 4% for 30 years gives you an ending value of \$3,243.
• \$1,000 compounded at 5% for 30 years gives you an ending value of \$4,322 (i.e., \$1,079 more than you’d have with a 4% growth rate).
• \$1,000 compounded at 6% for 30 years gives you an ending value of \$5,743 (i.e., \$1,421 more than you’d have with a 5% growth rate).
• \$1,000 compounded at 7% for 30 years gives you an ending value of \$7,612 (i.e., \$1,869 more than you’d have with a 6% growth rate).
• \$1,000 compounded at 8% for 30 years gives you an ending value of \$10,063 (i.e., \$2,451 more than you’d have with a 7% growth rate).

The key pattern to notice here is that each additional 1% of return adds more to the ending value than was added by the previous 1% of return. This is just how the math works. Another important observation — which is simply another result of the same mathematical concept — is that, if you cut the return in half (e.g., compounding at 4% rather than 8%), you’ll experience less than half of the growth in value.

So, that last percentage of return — the eighth percentage point — added the most to ending value. But there’s nothing particularly unique about that eighth percent of return. That is, if we removed whatever it was that caused that eighth percent of return (such that you’d be left with a 7% growth rate), that would would have exactly the same effect as removing the cause of, say, the second percent of return. In either case, you end up with a 7% annual growth rate, and you end up with the same \$7,612 ending value.

How This Applies to Dividends

The effects we’ve noticed above are amplified when we look at longer periods of time. And this is how people will sometimes come up with impressive-sounding factoids to convince you that dividends are more important than price appreciation.

For example, according to my 2012 edition of the Ibbotson Classic Yearbook — I haven’t purchased a copy for the last couple of years — from 1925-2011:

• Large-cap stocks in the U.S. earned a total return (before adjusting for inflation) of 9.66%, of which
• 5.42% came from price appreciation, and
• 4.24% came from dividends.

Over a period this long (87 years), the difference between a 5.42% return (from price appreciation only) and a 9.66% return is staggering. If you had only experienced the price appreciation, you’d have just 3.24% of the ending wealth that you’d have if you’d gotten the total 9.66% return.

But the key point here is that if you had somehow earned just the 4.24% return from dividends (and had experienced no price appreciation), you’d have even less money.

In other words, factoids like the above can show us that it is important to reinvest dividends rather than spending them (if you’re in the accumulation stage, trying to grow your portfolio, that is). But they do not tell us that dividends are more important than price appreciation.

New to Investing? See My Related Book:

 Investing Made Simple: Investing in Index Funds Explained in 100 Pages or Less
Topics Covered in the Book:
• Asset Allocation: Why it's so important, and how to determine your own,
• How to to pick winning mutual funds,
• Roth IRA vs. traditional IRA vs. 401(k),