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Don’t Join the Capital Gains Cult

Why You Should Focus on Dividends and Total Return - Not Capital Gains


Cash Dividends Not Capital Gains

Research has shown that 99% of the real, after-inflation gain in wealth investors earn on their shares of stock come from reinvested dividends. That's why you shouldn't be concerned when a company's stock price remains the same for three or four years.

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One of the most frustrating things I experience as a professional is encountering new investors who lament the fact that a stock they own hasn’t increased in price over several years. Yet, if you asked them the total cash dividend return they had earned during the same time period, it is likely they would give you a blank look. (As you have already learned in the beginner’s guide to dividends, dividends represent part of a company’s profit that is paid out to stockholders, who are the owners. They are declared by the Board of Directors and the total percentage of the profit that is paid out is known as the dividend payout ratio. Companies that are older, more mature, and don’t have as many opportunities for expansion likely have higher dividend payout ratios than those that are young, small, and fast growing.)

To illustrate my point: Imagine you were a partner in a private manufacturing business and your shares were valued at $500,000. For ten years, you hold on to this stock and the value never increases, yet during this same time period, you receive $1,500,000 in cash dividends. Obviously, this has been a great investment and you should be thrilled. Every year, you receive substantial checks in the mail as a result of your ownership. Yet, if you were to listen to the media, or look at a stock chart, you would consider your investment a total failure. Why? The financial media doesn’t include the total dividends received in determining the return shareholders have earned by owning a stock. In fact, in this case, your stock chart would show a flat line, leading many new investors to believe you had actually lost money after inflation over the decade you held your shares.

I believe this oversight is professional malpractice. Can you imagine going to a doctor that didn’t know how to read an X-Ray? The tragedy is that this phenomenon is relatively new. Up until the great bull market that began in the 1980s, it was said that the purpose of a company was to pay dividends. With people addicted to the pursuit of overnight riches and a gambling culture, it became much easier to envision yourself buying a stock and watching it go to the moon rather than buying a stock and slowly collecting cash.

If you need evidence this mindset pervades even the financial media consider this: A rather common mistake made by journalist is to point out that it took more than twenty years for the stock market to reach its former peak level after the Great Depression. Yet, several financial studies have shown that an investor that used disciplined dollar cost averaging and reinvested his or her dividends actually broke even in as little as 5-7 years, and by the time the market had returned to its former level, made an absolute mint.

Why This Should Matter to You

Most of the biggest companies in the world pay out a substantial, if not majority, of the annual profit in the form of a cash dividend. Firms such as Johnson & Johnson, Coca-Cola, General Electric, Wal-Mart Stores, and Exxon-Mobile often return the cash earned throughout the year to stockholders in the form of cash dividends and share repurchase programs. In Why Boring Is Almost Always More Profitable, I discussed the work of Dr. Jeremy Siegel, who showed that 99% of the real, inflation-adjusted return investors earn is the result of reinvesting their dividends, especially on quality firms such as these. That means that if you own blue chip stocks, you don’t need share prices to increase very much in value in order to grow wealthier with each passing year!

The implications for the average investor are clear: If you own an index fund that invests based on the S&P 500 or Dow Jones Industrial Average, most of your money is going to be put to work in companies with large dividend payout ratios. That means that most of your long-term return is going to come from reinvested dividends, not capital gains. It may be about as exciting as watching paint dry, but if you get rich in the end, it shouldn't matter.

Taking the Next Step

Once you understand this concept, you need to read Calculating Total Return and CAGR. It will explain how you can use some simple algebra to determine the rate of return you earned on an investment during the time you owned it, including the dividends you received. You may also want to read Why Total Return Is More Important Than Changes In Market Capitalization.

You will also want to read Income Investing for Beginners - a 10 Part Guide to Choosing Great Investments That Generate Cash.

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