I am amazed at the number of investors and advisors that view dividends as irrelevant, or even worse, something to avoid. These folks must not understand what they are purchasing by investing in an individual stock, mutual fund or ETF. That is, because the only thing a retail investor acquires by investing in equity securities (whether an individual stock, mutual fund or ETF) is the right to receive future dividends.
In short, dividends not only matter; they are the only thing that matters.
To understand why this is the case, you have to understand what equity securities actually represent in the hands of retail investors. Despite what you may have previously read or heard, a share of stock in a publicly traded company is not a fractional percentage ownership in the underlying company, or its assets or even its earnings or cash flows (except to the extent paid as dividends). Rather, a share of stock is a hybrid contractual and legal instrument that entitles the holder to a certain bundle or rights.
These rights include, first and most importantly, the right to receive dividends when and if declared by the company’s board of directors, the right to vote on the election of the Board of Directors and other matters brought up for a shareholder vote, the right inspect the books and records, the right to sue the directors or management for breach of duties or mismanagement and the obscure right of appraisal. The only one of these rights that has any practical relevance to retail investors is the right to receive dividends. All other rights are irrelevant as I will explain.
Let’s consider voting rights, for example. As a shareholder, you have the right to vote on the election of directors and other shareholder proposals that are appropriately brought up for a shareholder vote. SCRATH THAT. If you own stocks through mutual funds and ETFs (like I do and the majority of retail investors do), you don’t have that right. The fund manager exercises that right for you without your input. Even if you own shares in individual stocks, your vote does not matter. Institutional investors (such as Vanguard, Fidelity and Blackrock) determine the outcome of shareholder votes. Don’t bother filling out your proxy card to vote your 100 shares of XYZ Company. Nobody cares and you have better things to do.
What about the right to inspect the books and records? Yes, your 100 shares of XYZ Company (assuming you own them directly and not through a mutual fund or ETF) theoretically entitle you to a limited right to inspect XYZ Company’s books and records. But you can’t exercise that right by showing up at XYZ Company’s headquarters on a lazy Tuesday to take a look-see. That would resemble something akin to ownership, and again, owning shares of a publicly traded stock does not constitute an ownership interest in the underlying company. Instead, you would have to jump through a lot of hoops to ensure your demand complies with the requirements in the company’s bylaws, and you would likely have to hire a team of high-priced lawyers to enforce that right. If you do all that, you may, at some point, actually get limited access to XYZ’s Company’s books and records. Congratulations.
Retail investors would encounter similar obstacles and expense in attempting to exercise many other rights inherent in share ownership, such as the right to sue the Board and management or the right of appraisal in connection with a merger or acquisition. These rights may be relevant to groups such as the plaintiffs’ bar and activist investors, but do not have any practical application for retail investors.
That really leaves only one right of share ownership that is relevant to retail investors. That is, the right to receive future dividends. The right to receive dividends is the only thing retail investors acquire by purchasing equity securities in the public markets for all practical purposes and the only thing that gives a share of stock in publicly traded company, mutual fund or ETF any inherent value when held by a retail investor.
Absent dividends, investing in the stock market would not be investing at all; it would be speculation. Investing is the practice of purchasing an asset with the aim of realizing future cash flows that the asset is expected to generate. Speculation, on the other hand, is the practice of buying something with the expectation of selling it someone else in the future for more than you paid for it. Speculative assets often have little, or no, inherent value. The expectation of future dividends is the only thing, at least as applied to retail investors, that separates investing in the stock market from speculating on things such as gold, stamps, baseball cards, etc. or even worse, the latest crypto/NFT nonsense.
Warning. Please note that none of this means that one should buy securities solely based only on their current dividend yield. That is a horrible strategy in my opinion and can result in catastrophic losses. The key to dividend investing, in my opinion, is investing in a diversified portfolio of individual stocks, mutual funds and ETFs that pay consistent, stable dividends with a historical record of dividend growth.
At this point, you may be thinking “So what? Enough of the theoretical stuff. I invest in stocks for appreciation. I don’t care about the miniscule annual dividend.” First, if you are a speculator, I can’t really counter these thoughts and can only wish you good luck, which you will need lots of to be successful. If you consider yourself a long-term investor, you may be underestimating the importance of dividends in your long-term portfolio appreciation.
First, do you realize that the substantial majority of the long-term growth from a 30-year portfolio has historically been directly attributable to dividend reinvestment as opposed to market appreciation? Let me restate that as a declarative to let that sink in. The substantial majority of the long-term growth from a 30-year portfolio has historically been directly attributable to dividend reinvestment as opposed to market appreciation.
For instance, according to a cool calculator on the website Dollars and Data, which can be found here: S&P 500 Historical Return Calculator [With Dividends] – Of Dollars And Data, a $1,000 investment in the S&P 500 index on January 1, 1994 would have been worth $9,905 as of December 31, 2023 without dividends reinvested. The same $1,000 investment would have been worth $17,271 as of December 31, 2023 with dividends reinvested, or 74% more than the ending value of the portfolio without dividends reinvested.
Note that I used this period as it was the most recently completed 30-year period as I wrote this and also estimates the average retail investor’s pre-retirement investing career. The result would be amplified on previous 30-year investment periods. For example, a $1,000 investment in the S&P 500 on January 1, 1964 would have been worth $6,095 as of December 31, 1993 without dividends reinvested, or $18,716 (over 3x more) as of December 31, 1993 with dividends reinvested.
Although these data points illuminate the impact that dividend reinvestments have on the long-term growth of a stock portfolio, they do not come close to capturing the full impact that dividends have on long-term market returns. That is because dividend growth has been the fundamental driver of historical long-term stock market appreciation. In other words, the primary reason stocks have broadly appreciated historically over the long-term horizons is because dividend rates generated by the underlying companies (as a whole) have broadly increased over long-term horizons.
The Gordon Growth Model, created by the economist Myren J. Gordon in the ’50s, illustrates the relation between dividend growth and long-term market appreciation. Gordon’s model purported to calculate the intrinsic value of an individual equity security based on its current dividend rate and its expected dividend growth rate over time in excess of then the current risk-free rate of return. It is essentially a discounted cash-flow model to calculate the intrinsic value of an equity investment based on expected future dividends.
The Gordon Growth Model can be inverted to predict future long-term returns of equity securities. According to the model, the long-term rate of return of an equity security (or basket of equity securities) can be predicted by summing the then current dividend yield and the expected future dividend growth rate of the security.
For example, if the current dividend yield of a S&P 500 index fund is 2% and you expect the current dividend stream to grow at a cumulative average annual rate of 5% over the next 30 years, the Gordon Growth Model would predict an average annual nominal rate of return for the S&P 500 index fund of 7% (2% current yield plus 5% growth rate) over the next 30 years.
Let’s see how the Gordon Model would have done in predicting returns generated by the S&P 500 over the past 30 years. Based on publicly available data, the S&P 500 index TTM dividend yield as of December 31, 1993 was approximately 2.70%. State Street’s S&P 500 index ETF (ticker symbol: SPY) paid a total of $1.134 of dividends per unit in 1993 and a total of $6.633 in dividends per unit in 2023. The equates to a cumulative average annual dividend growth rate (CADGR) of approximately 6% from January 1, 1994 through December 31, 2023.
Based on the then current dividend yield of 2.70% and a cumulative average dividend growth rate of 6% over 30 years, the Gordon Growth Model would have predicted a total cumulative average rate of return of 8.70% (2.70% plus 6% equals 8.7%) for the S&P 500 index from January 1, 1994 through December 31, 2023. The Dollars and Data calculator I linked above calculates the S&P 500 index cumulative average annual total rate of return (with dividends reinvested) at 9.99% for the same period. The model was in the ballpark, but about 1.30% to the low side. What explains the difference? In short, noise. But I will explain further.
Even though the Gordon Growth Model demonstrates that long-term market appreciation is primarily attributable to dividend growth over time, it cannot predict how market participants will collectively value the perpetual dividend cashflow stream generated from an investment at any particular time. Market valuations are impacted by a number of factors, including returns available to investors in alternative less-risky assets, general economic conditions, investors’ collective sentiment about future prospects (i.e., future dividend growth) and fear and greed emotions that drive short-term market volatility. The best measure of market valuation, particularly when applied to a basket of equity securities such as stocks in the S&P 500 index, is its then current dividend yield. The lower the dividend yield, the higher valuation and vise vs. Sometimes the market participants overvalue the dividend cashflow stream; other times they undervalue it.
The culmination of these factors resulted in market participants valuing the dividend cash stream generated by the stocks in the S&P 500 higher in 2023 than they did in 1994. As of December 31, 1993, the S&P 500 dividend yield was approximately 2.70%. As of December 31, 1993, it was approximately 1.40%. The difference being approximately 1.3%, which is the same percentage by which the Gordon Growth Model under-estimated S&P 500 total returns over the same period. See above. I think this is coincidental as the Gordon Growth Model is not that precise, but it does demonstrate that the Gordon Growth Model has practical application outside of academia and is still relevant several decades after Professor Gordon conceived it.
My point here is not to promote the Gordon Growth Model as the ultimate tool to predict future market returns (although I do think it is useful for long-term investment planning). The point is to demonstrate that dividend growth was the predominate, inherent and fundamental factor that drove historical long-term market appreciation and will be the key factor that determines future long-term market returns. Everything else is just noise having transitory and relative marginal impact over long-term horizons.
If you are still NOT convinced that dividend growth is the predominate factor that has driven historical long-term market appreciation, consider the following questions.
How could SPY’s market valuation NOT increase dramatically from 1994 to 2023 when its per unit annual dividend rate increased from $1.134 in 1993 to $6.633 in 2023?
What other factor or factors could possibly explain SPY’s appreciation over this period if not for that impressive dividend growth?
In conclusion, the only thing that retail investors acquire, for all practical intents and purposes, by purchasing an individual stock, mutual fund or ETF is the right to receive future dividends paid by underlying companies. The expectation of future dividends is the only thing that give public-company equity securities inherent value in the hands of retail investors. The reinvestment of dividends has historically accounted for the substantial majority of the long-term value accumulation of a typical retail investor’s equity portfolio. Further, dividend growth has been, and will continue to be, the predominate driver of long-term market price appreciation.
In short, dividends not only matter; dividends are all that matter.
Thanks for reading and please leave your thoughts in the comments section below. I would be particularly interested to hear from those in the anti-dividend camp.
Disclaimer: None of the foregoing is intended as investment advice in any manner. I’m not an investment advisor or financial professional. I’m some anonymous dude with a keyboard that enjoys sharing thoughts on subjects I’m interested in, including personal finance, and reading what others think. Please do not act or rely upon anything posted on this site to make investment decisions or for any other purpose. You would be a fool to do so. I do not have a fact checker or editor and am prone to mistakes. Accordingly, I make no representation as to the accuracy or validity of any data, facts or statements that appear on this site.