As it turns out, this is quite a tricky question to answer. Of course, dividends represent 'cash-in-hand' for investors - but this cash is taken out of the businesses that generated the cash. And most companies can get a better rate of return by retaining earnings and reinvesting in the business. So, logically, companies with higher dividend yields - on average - should show slower capital or market price growth.
So what happened in the S&P 500 in the last 20 years?
This graph from Bloomberg compares two versions of market returns:
- total market returns, including reinvested dividends
- market returns based solely on price appreciation, with no reinvested dividends
The graph and accompanying text imply that reinvesting dividends is responsible for 43% of the total returns of the S&P 500, which itself quadrupled over the period (+394%). That's great news, isn't it? Doesn't that reinforce your income-investing bias?
|Source: Bloomberg Businessweek|
But hang on. This doesn't mean that if you bought dividend stocks you would necessarily have been better off. As described above, if you only bought dividend-paying shares you would normally expect the capital growth to be slower than for the rest of the market that doesn't pay out its cash in dividends. So, if you didn't reinvest the dividends you would be worse off.
And the graph also assumes - somewhat perversely - that reinvested dividends would be invested in the whole market, rather than just other dividend shares. So the overall return for a dividend-oriented investor could be quite different to what is shown on the graph - with an even higher proportion of gains from reinvested dividends. For more on this theme, see the retailinvestor.org website, which challenges many so-called investment 'truisms'.
So we need to be cautious how we interpret the data: there is a well-recognised tendency for people to accept evidence that supports their existing bias and ignore evidence that 'doesn't fit'.
But where does that leave us DIY Income Investors? Well, first of all, investing for income is not the Holy Grail of the stock market (although my portfolio total return in 2012 is rapidly - and unexpectedly - approaching 30%): there are many other, perfectly valid investment approaches.
However, I do think it is a practical approach for the DIY investor:
- a focus on income forces you to think about how much income you need and what you are going to spend the money on; in other words it leads to a review of expenditure
- a focus on yield encourages you to think about risk
- high-yield securities, by nature are contrarian, as are most great investors
- a 'buy and hold' investment approach incurs fewer dealing costs and requires much less time and effort that one that requires frequent interventions (i.e. to anticipate 'highs' and 'lows')
- comparing yield makes it easier to compare different asset classes
- investing for income prepares you for generating income in retirement
So, keep on investing for income (if you are convinced) - but be cautious how you interpret the evidence.
I am not a financial adviser and the information provided does not constitute financial advice. You should always do your own research on top of what you learn here to ensure that it's right for your specific circumstances.