With dividends representing a central source of returns, it should come as no surprise that, in aggregate, a large fraction of the market’s total return has come from dividends. From 1975 to 2009 the MSCI World Index (a measure of the performance of stocks around the world) provided an average total return, adjusted for inflation, of 6.9% per year. Of that total, dividends accounted for 2.9 percentage points, and capital gains 4.0 percentage points. In other words, dividends were nearly as important to overall returns as price gains.
How do dividend stocks perform? Take a look at the Dollars from dividends graph to the right which shows the performance of two U.S. stock portfolios. From 1980 through to the start of 2010, if you had simply invested in the whole market, as represented by the S&P 500, each dollar would have grown to almost $25—for an 11.2% a year return on average. (For simplicity’s sake these returns neglect fees, taxes, and inflation.)
However, if you invested in a portfolio of stocks with the highest 30% of dividend yields, as shown by the line in orange, you would have soundly trounced the market with average annual gains of 13.0%. That’s a 1.8-percentage-point annual advantage for high-yielding stocks versus the market. (The dividend portfolio was put together by Kenneth French, professor of finance at Dartmouth College, and he rebalanced it on an annual basis.)
Don’t get too greedy. Before loading up willy-nilly on stocks that pay high yields, it’s important to take a step back and take note of an important detail: stocks with extremely high-dividend yields have not fared well.
That’s because these super-high yields are often more the result of falling stock prices than of rising dividends. If a stock is crashing, but the dividend hasn’t been cut (yet), the dividend suddenly represents a much higher percentage of the price, even though the dividend itself is not increasing. As a result, a very high yield can be a danger sign, and such stocks have a nasty habit of reducing or eliminating their dividends altogether. In practical terms, that means you should focus on stocks with yields that are well above average, say in the top 30% of yields, but not in the sky-high top 10% group. As a safety factor, conservative investors should also stick with stocks in a large blue-chip index such as the S&P/TSX60.
Some stocks to get you going. The Dividend darlings table above highlights 12 stocks that fit both of the above criteria: the yields are high—but not too high—and all of them are large blue-chip companies. Banks and financial institutions dominate the list, and a variety of utilities are also well represented. As a result, our list is overly concentrated in only a few industry groups, which is a risk factor. That’s why investors often like to supplement their dividend portfolios with foreign stocks for better diversification.
It is wise to take a long-term approach when investing in dividend stocks because most can be held for years, provided they don’t become significantly overvalued. You can take your time and slowly build up a portfolio of 20 or more dividend payers that, with luck, will fund your retirement.
What can go wrong? The 1980 to 2010 period graphed above was particularly good to investors. Regrettably, stocks are currently pricier than they were in 1980 and returns over the next decade are likely to be somewhat less than those of the last 30 years.