Investing In Dividends For Dummies
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Total return measures a stock's total performance from both dividends and share price appreciation. If a stock starts the year at $50 and pays a $4 annual dividend, the dividend yield is 8 percent: $4 / $50 = 8 percent. If the stock gained $6 to end the year at $56 (up from $50), it saw capital appreciation (increase in value based on its market price) of 12 percent:

$6 / $50 = 12 percent

Add the dividend yield and capital appreciation together, and you get the total return of 20 percent. (Total return of an index over many years often includes the reinvestment of the dividends on an annual basis.)

From January 1926 to December 2008, the S&P 500 Index (and its predecessors) delivered an annualized total return of 9.69 percent per year. The shocking aspect of that is that over those 83 years, price appreciation (rising share prices) accounted for only 5.5 percentage points of that 9.69 percent. Dividends actually accounted for the remaining 4.19. In other words, dividend income comprised 43.27 percent of the S&P's returns:

4.19 percent / 9.69 percent = 43.27 percent

The numbers from the Dow paint a similar picture. From January 1, 1930, (about two months after the crash of 1929) to December 31, 2008, the cumulative return on the Dow was 5,914.64 percent or 7.96 percent on an annualized basis. Price appreciation accounted for just 4.62 of that 7.96 percent points, and dividends accounted for the other 3.34. Looking at it another way, dividend income comprised about 41.96 percent of the Dow's total returns:

3.34 percent / 7.96 percent = 41.96 percent

An annual rate of return is the return for a 12-month period, such as January 1 to December 31. An annualized rate of return is the rate of return for a period longer or shorter than one year. The number is either multiplied or divided to determine an equivalent return for a one-year period.

Dividends made up 43.27 percent of the S&P's total return and 41.96 percent of the Dow's total return. These numbers are pretty consistent and clearly indicate that if you forgo dividends, you give up more than 40 percent of the potential profits you can derive from the stock market.

Investment returns in the form of dividends take on even greater importance in a bear market. In bear markets, stocks can go for years without posting any significant capital gains, but companies often continue to pay dividends. Dividends may provide the only returns you receive when share prices drop or flatline.

To gain a clearer perspective, take a look at the Dow Jones Industrial Average over the period from January 1, 1999, to December 31, 2008. During this period, the stock market experienced some serious ups and downs — the rally of the technology bubble that peaked in early 2000, the ensuing crash that bottomed out in 2002, the rally of the housing bubble that lifted stocks to an all-time high in 2007, and then a plunge of more than 50 percent in 2008 through early 2009.

We can explore what would have happened if you had invested $100 in the Dow stocks on the last day of 1998. By the end of 2008, based on share price appreciation alone, that $100 would be worth $95.59, representing a return of –4.41 percent. Including dividends, however, the total return would be $117.95 — a nearly 18-percent profit on your investment and a 22.36-percentage point jump over price appreciation alone. And that doesn't even include reinvesting the dividends!

About This Article

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About the book author:

Lawrence Carrel is a contributing writer for The Journal of Indexes /, where he writes a weekly column on the exchange-traded fund and indexing industries.

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