This is a guest post from Robert Brokamp of The Motley Fool. Robert is a Certified Financial Planner and the adviser for The Motley Fool’s Rule Your Retirement service. He also has a blog, Twittering thing, and other things that are supposed to be important but he often forgets about, such as hygiene. Robert contributes one new article to Get Rich Slowly every two weeks.
A few weeks ago, I attended the Morningstar Investment Conference and took in the insights and predictions of all kinds of mutual fund managers and financial experts. On the whole, these folks weren’t too optimistic about earning exceptional returns on any kind of investment. Bonds and cash have paltry yields, and stocks aren’t as cheap as they were a couple of years ago. I think the collective investment advice of the event could be summed up by a line from Tom Hancock of money-management firm GMO, who said, “The only thing I like about stocks is they’re not bonds.”
During the opening session, Pimco co-chief investment officer and bond fund manager Bill Gross bemoaned the low rates on Treasuries. He also argued that investors shouldn’t expect 10% returns from stocks. But at the end of his talk, Gross suggested investors look for a solid, inflation-beating return from companies that pay steady dividends — companies such as Coca-Cola, Proctor & Gamble, Johnson & Johnson, Southern Company, and Duke Energy. (Full disclosure: I own shares of Johnson & Johnson, and when children pass me in the street they scream, “Gross!”)
Bill Gross was singing a tune similar to what has been wafting from the pages my Rule Your Retirement newsletter over the past few months: Stocks are not priced for exceptional returns over the next decade, and in a sideways market, dividends play an even bigger role in your portfolio. (For more on the current valuation of the stock market and what that says about future returns, read this update from the website of Doug Short, a cyber-friend and “retiree” who — like J.D., the editor of this blog — turned his personal website into a successful business.)
As I listened to Gross, I wondered what would happen at the extreme: What if stocks didn’t gain a penny and all we received was dividends? I fired up Excel and found some fascinating figures.
Saved by the Dividends
First off, let’s recap the benefits of stock dividends.
Unlike the interest from bonds, dividends tend to grow over time, historically at a rate that exceeds inflation. For most investors, the smart strategy is to use those dividends to buy more shares of stock, so that they’ll receive even more dividends, so they can buy even more stocks, and so on. In a previous post, I likened dividend-paying stocks to money-growing trees that produce a little more financial fruit each year. If you buy more trees with that cash crop, you reap even more fiscal flora. Given long enough time, you could have a whole greenhouse producing the green stuff.
To illustrate how this can pay off over the long term, let’s move from stalks to stocks and assume you own 1,000 shares of a stock that trades for $100, for a total investment of $100,000. (Note that this is just a hypothetical illustration; very, very few people should have so much money in one stock; also, the same principles apply to a mutual fund that pays dividends, even if you invest just $100.) The stock has a 3% dividend yield, so over the past year you received $3 per share, or a total of $3,000 in dividends.
Unfortunately, the price of this stock doesn’t move much over the next decade. In fact, it doesn’t move at all. Here’s what such an investment would look like after 10 and 20 years, if the dividend increases 6% a year but the stock price doesn’t budge.
|Now||After 10 Years||After 20 Years|
|Value of Investment||$100,000||$151,726||$319,120|
|Number of Shares Owned||1,000||1,517||3,191|
|Dividends Received During the Last Year||$3,000||$7,885||$28,943|
While ten or twenty years of no price movement in a stock is disappointing, all is not lost. By reinvesting the dividends, you still earned money, thanks to owning more shares that each pay higher dividends.
Getting Rich Slowly
Like all illustrations of compounding growth — i.e., earning interest on interest, or, in this case, dividends on dividends — it’s not something that will make you wealthy overnight — but it could help you get rich slowly. (Hey, that would be a great name for a website!). Also, like all illustrations of compounding growth, it looks better the more time you give it.
If you can stretch your investing horizon even further — or if you’re trying to convince a young investor to get started early — 30 years of reinvested dividends, growing 6% a year, will turn that $100,000 starting sum into $1.2 million, for an 8.6% annualized gain.
Earning 4% or even 8% on your long-term money may not sound exciting to some people. But that’s not tragic considering it’s based on a dire scenario: a stock that doesn’t increase in value for 10, 20, or 30 years. Of course, I hope that any stock or mutual fund you buy does increase in value. And when that happens, dividend reinvestment pays off even more, because you’re accumulating more shares to benefit from that capital appreciation.
An Uncertain Future
This article isn’t intended to persuade you to buy stocks. Stocks are volatile and risky and often stinky and all that; I am not offering boilerplate legalese when I say that I’m not 100% confident stock investments will be worth more in 20 years than they are today.
At the Morningstar Investment Conference, BlackRock CEO Larry Fink said, “Anyone who plans to be around in 10 years should be in equities.” It’s not hard to see his point when you look at the alternatives. On the other hand, if you read the aforementioned link to Doug Short’s site, you won’t feel so sanguine about stocks.
As for me, I continue to own stocks in all forms — index funds, some actively managed funds, a handful of individual companies — but I don’t expect exceptional returns; I’m basing my retirement on my ability to save, not on the return I earn on the savings. And I expect that dividend reinvestment will be a large source of any returns I receive.
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