Investing in Stocks: It’s Not as Bad as You Think

Stocks stink.

That's something you hear a lot these days, and with good reason. The Standard & Poor's 500 sits at around 1060, a threshold it first crossed in the beginning of 1998. In other words, that index of stocks in 500 industry-leading American companies — companies like ExxonMobil, Johnson & Johnson, Coke, and McDonald's — has gone up and down a lot over the past 12 or so years, but has ended up in the same place where it started.

So you might think that if you invested $10,000 in the S&P 500 through something like the Vanguard 500 index fund back in the spring of 1998, you might still have just $10,000. But actually, you'd have approximately $12,000 — not great, but better than nothing.

How is that possible? Permit me to explain with a metaphor.

If money grew on trees
If money grew on trees...Let's imagine that you could buy a plant that grew money. That would be one valuable shrub, so it wouldn't come cheap. In fact, let's say a plant that produced $2 a year costs a hundred bucks. Still, you buy a whole bunch of them because:

  1. Each one produces $2 today and will provide a little more money each year as the plant grows, perhaps $4 in a decade, and
  2. In the future, another gardener might pay you more than $100 each for these plants.

What do you do with the cash your plants are providing? Buy more money-growing flora, so you can use the greenbacks they produce to buy, yes, more plants. When the market decides that they're worth more than $100, you get fewer of them. When the market thinks they're worth less, you'll be able to buy more.

By the time you retire, you'll own a whole lot of plants and, as they mature, they'll each produce more money each year — perhaps $10 or more apiece. You may opt to sell some when the market catches on and offers a price higher than what you paid. But even when you retire, you should still own many of these shrubs because you'll need to harvest the cash to pay your bills.

Stalks for the long run
Okay, we all know that money doesn't grow on trees. But most stocks pay dividends; plus, historically, over the long term those dividends increase. When you reinvest those dividends — as most people do — you're automatically dollar-cost averaging (that is, buying more shares when prices are low and fewer when prices are high). You gradually accumulate more shares, which gradually pay bigger dividends, which are used to buy more shares, which pay bigger dividends…and so on.

The same goes for mutual funds that invest in stocks. In fact, let's look at the real-life example of the aforementioned Vanguard 500, which attempts to mimic the performance of the S&P 500 at very low costs. (I own the fund myself.) Not every company in the S&P 500 pays dividends, but this will provide an illustration of how dividend reinvestment can pay off.

Had you invested $10,000 in the Vanguard 500 Fund on 31 March 1998, you'd have bought 97.84 shares, according to numbers provided to me by Vanguard. Over the subsequent year, the fund paid out $1.06 per share in dividend distributions.

Technical note: Mutual fund shares also pay out capital-gains distributions, but not as consistently. So, for simplicity's sake, we'll focus mostly on dividends.

Fast-forward to July 2010. You now have 121.15 shares — almost 24% more than you started with. That's because you were accumulating more shares with all those fund distributions. But the news gets a little bit better. For the past year, the Vanguard 500 paid out $2.08 in dividend distributions. Over the past 12 years, the dividend almost doubled. Plus, you have 24% more shares paying that bigger dividend, which will buy more shares…well, you know the drill.

“Big deal!”
I know what you're saying: “Making a 20% total return over 12 years is lame! I know this blog is called Get Rich Slowly, but that's ridiculous.”

I agree. As I said in the title of this post, investing in stocks hasn't been quite as bad — but it's still been bad. In fact, the last decade or so has been the worst period for blue-chip U.S. stocks since 1926, including the period encompassing the Great Depression (according to data from Ibbotson Associates).

I bring all this up to illustrate a few points:

  • Indexes can be misleading. Stock barometers such as the S&P 500 and the Dow Jones Industrial average are price indexes; they just measure the change in prices of the underlying stocks, and don't factor in dividends or their reinvestment. That's unfortunate, because…
  • Over the long term, dividends matter. Historically, dividend reinvestment has accounted for approximately one-third of the total return of stocks. That said, yields on stocks are pretty low these days, which means stocks aren't a great bargain. But for my long-term money (I don't plan to retire for another 30 years) I'm betting that the 2% to 3% yield on a broadly diversified portfolio of stocks — along with some capital appreciation — will beat the alternatives, namely, low-yielding cash and bonds (though I own some of each for diversification's sake). This brings us to our third, final, and perhaps most important point…
  • Don't invest in just one type of plant stock. Over the past decade or so, large-cap U.S. stocks — the type you find in the S&P 500 — have been the just about the worst type of investment to own. Name another type of stock (small-cap stocks, international stocks, real estate investment trusts) and chances are, as a group, they beat the S&P 500. As I explained in this video (just in case you're dying to hear my nasally voice or see my hair while it still exists) and touched on in this previous GRS article, a properly diversified portfolio holds stocks of all types, sizes, nationalities, and flavors, with bonds or cash thrown in to suit your risk tolerance or financial needs (e.g., a retiree should have five years' worth of income that is expected to be covered by saving sequestered from stocks and in something super-safe, like cash, CDs, or short-term bonds).

I have no crystal ball. I don't know whether U.S. stocks or international stocks or cash or plants will be the best-performing asset class over the next decade or few. If you think the stock market is a sucker's bet, I'm not here to argue with you. Just taking a look at the Japanese stock market — which is still down 70% from its 1989 peak, despite being the second-biggest economy in the world — should make anyone appreciate the risks of stock investing.

But if you've decided to make stocks a part of your long-term portfolio, I think that understanding the role dividend reinvestment plays will give you a little more confidence to hang in there.

J.D.'s note: Robert's “stalks for the long run” pun above made me die laughing. I realize it's an esoteric personal-finance writer joke, but it's a funny one all the same.

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Mich @BeatingTheIndex
Mich @BeatingTheIndex
9 years ago

No one knows where the economy will be in the next few months. Dividend paying stocks will pay you while you wait for the markets to recover. No loss there!
I am looking to increase my dividend paying stocks as markets hit more air pockets since it’s a great time to buy them for long term.

Rob
Rob
9 years ago

Dividends are a big reason I will keep investing in stocks (well…ETFs really). I love seeing my dividends get paid out and then reinvested, even with how small they are at the moment.

Mr. GoTo
Mr. GoTo
9 years ago

Before you become enthralled with the concept of stocks and dividends – even for the long haul – consider the research and views of Prof. Zvi Bodie on the risks of equity investing. Also consider the numerous companies that cut or eliminated dividends during the past two years.

Nicole
Nicole
9 years ago

Dividends make me happy.

Passive money that just appears in my bank account every quarter makes me feel rich!

Though I vaguely understand there’s a trade-off between dividends and price and I should be equally happy dripping as not. But sometimes I like just taking the money. Right now I have indexes/ETFs set to Drip and single stocks (that I didn’t want to sell from a previous life when my father was handling my investments) set to pay me cash. Which I can then use to invest in indexes or pay down mortgage if I feel like it.

fantasma
fantasma
9 years ago

Now this is a topic that I am avidly interested in. So very little is ever said about “Drip” investing. Its not the easiest topic to research online b/c so few people are actually into that type of investing. I know it has its niche but I wish more resources were out there.

Jason
Jason
9 years ago

I think the tree/shrub analogy is misleading. When you use an example such as a tree you are unfairly applying ideas such as “growth, growing, stability”, the qualities of a tree. It takes quite a bit to kill a full grown tree… quite the opposite is true to your stock portfolio. I understand what your saying, but I think comparing stocks/dividends to trees or shrubs gives them a unintended or maybe a intended positive spin. No one thinks about a tree that doesn’t grow. There are plenty of stocks or portfolio of stocks that don’t grow. Maybe you should have… Read more »

Financial Samurai
Financial Samurai
9 years ago

It’s pretty bad, especially in the past 10 years, although it seems like the online community always make money!

I’d rather have had my money grow a 5% compounded for the past 10 years than have money in the markets. Peace of mind, and a 80% increase is a wonderful thing.

Kevin M
Kevin M
9 years ago

I love income producing assets like dividend stocks, or even bonds. To me it makes much more sense than buying a stock and hoping for a capital gain. (Of course, I still hope the stock price of my dividend stocks increase.)

Rob Bennett
Rob Bennett
9 years ago

I have no crystal ball. I do. Stocks have always provided good long-term returns when purchased at reasonable or good prices. Stocks have always provided horrible long-term returns when purchased at insanely high prices (like those that applied from January 1996 through September 2008). There’s a reason. When you overpay for something (stocks were priced at three times fair value in 2000), it is not realistic to expect to receive a strong value proposition. Pretending that it takes a “crystal ball” to understand this common-sense insight is Get Rich Quick thinking. The Buy-and-Hold concept is rooted in Get Rich Quick… Read more »

Raghu Bilhana
Raghu Bilhana
9 years ago

I am a firm beleiver in that, anyone should be investing in the stocks only if he/she is not going to take that money out anytime in the next 5 years.

The stocks are underperforming now, but they have overly overperformed during 1984-1999.

The first five to six chapters of “Common sense on mutual funds” by Jack Bogle provides you all the answers and confirms some points made by the author in the article above.

Coley
Coley
9 years ago

“I love income producing assets like dividend stocks, or even bonds. To me it makes much more sense than buying a stock and hoping for a capital gain.”

I get what you’re saying. But does it really matter if a company pays out a certain dividend per share, or reinvests those earnings in the company, theoretically making the value of the share higher? As long as the underlying earnings are the same, right? I don’t know.

I’m waiting for Mike Piper to pipe up.

MichaelD
MichaelD
9 years ago

I love investing in stocks. Last year was really awesome for me. I loved making a 200% gain on certain stocks. This year I have gone back to investing in good dividend paying stocks.

Kris
Kris
9 years ago

It’s refreshing to see some information on GRS outside of ETF’s and Index funds. I’ve been following the blog for nearly 3 years and feel like discussing and exploring the different investment options and theories is the next logical step in personal finance. After getting my personal finance house in order I now have money to invest. In general, I think it’s safe to say that part of getting rich slowly involves investing in the markets. With that said, what are the different investment theories and can somebody break down the financial lingo in laymen’s terms? Can we explore more… Read more »

elisabeth
elisabeth
9 years ago

I don’t reinvest my dividends. I feel that good stocks will appreciate and earn money in other ways. I can always save up and buy more of a really good stock, and over time a few of my stocks have even split, which was like buying more…. At the same time, when stocks are doing badly but still paying dividends, getting those dividends (not reinvesting them!) means I am at least getting something out of my investment — and I can if I choose put the dividend income into CDs (where at least I won’t lose capital) or use it… Read more »

Janette
Janette
9 years ago

How is that ball working for you Rob? DRIP and hold. Completely pulled out of the market twice. Look for excellent companies and watch them carefully. Ford at 3, Harley at 15. It seems like my non drips are doing the worst- AVAV being one of them. Mutual funds and ETFs were good for me when work took up more time- not any longer. Once owned international stocks- now I look for international US companies. As much as people complain- the US government doesn’t go in and take over profitable companies—cannot say that about the rest of the world. Burned… Read more »

Nicole
Nicole
9 years ago

@8 Kris

After reading about a zillion books and articles on behavioral economics, I am convinced that ETFs and Index funds ARE the way to go. Nothing else beats the market (except hindsight, of course), or really even matches the market when fees are added in. You might enjoy “Why Smart People Make Big Money Mistakes and How to Correct Them” by Belsky and Gilovich, though there are a dozen other more recent books that cover the same material.

Daniel
Daniel
9 years ago

Elisabeth (post 9), please don’t take this the wrong way. But I think your investment strategy is way too conservative. Here are a couple of reasons why I do not like your dividend strategy: 1. Counting primarily on a stock to appreciate in value subjects you to capital gains (and the capital gains tax) when you sell that security. The tax rate for capital gains is higher than that for dividends. 2. You overlook the value of compounding, which can create wealth out of small sums of money over time. I think you are right to take a conservative approach,… Read more »

The Editor
The Editor
9 years ago

Understanding how emotions influence investment decisions in the stock market also helps. People generally invest based on emotion, then justify with logic.

Ely
Ely
9 years ago

@ JD, I had the same reaction to that awful pun. 😀

Jackie
Jackie
9 years ago

Hah! I loved the “stalks” line too 🙂

I started investing in individual stocks for the first time a couple of months before the crash of 2008, so I haven’t ever really experienced a “normal” time of investing in the stock market. But maybe that’s exactly the point when it comes to stocks: there is no normal. Instead, there’s making the best decisions possible with the most information obtainable.

Suzanne
Suzanne
9 years ago

@ Elizabeth, I have to agree with Daniel. Stocks do have a certain risk, but there are other kinds of risks as well, including the risk of not having your savings grow enough over your lifetime to generate the income you will need in retirement. I would argue the opposite of your statement “anyone who isn’t already rich should only use money that you can afford to lose”. Rich people can afford to have subpar returns. The non-rich will need their money to grow as much as possible since they have less ability to save additional dollars to make up… Read more »

KC
KC
9 years ago

The problem with DRIPs is when you sell. And let’s face it, you do sell – you pay for education, you buy a car, you retire. But with DRIPs you have all these transactions you have to report to the tax man and it can be a booger. I just prefer to save my dividends in my brokerage account until I’m ready to purchase another stock (or the same stock if I think its a good value). This way I dont’ have 4 small purchases a year (or more if you own multiple DRIPs) – I only have one large… Read more »

My Personal Finance Journey
My Personal Finance Journey
9 years ago

The point about dividends causing the returns of an S&P500 mutual fund to be higher than stated by the index is a good one.

Another phenomena that would cause an individual investor’s returns in this mutual fund to be higher is just due to periodic investment of new funds when they become available through thier salary (ex – 401k account).

By using dollar value and dollar cost averaging with new funds, your returns will be higher than are simply stated on the 10 year performance of the index.

Landon
Landon
9 years ago

Great, great article. I just touched upon this subject on a recent posting on my blog and inspired a debate amongst my friend about passive vs. active investing (he trades Forex/options like a mad man everyday). I also like the tree analogy, I personally use the stream analogy when discussing investments (“multiple streams of income”).

As an addendum, my friend predicted the market would tank this week. Hasn’t happened so far; let’s see how far statistical analysis gets him!

Kevin M
Kevin M
9 years ago

@Coley (#11) – your reinvestment theory assumes either:
a) continual growth of earnings or
b) the ability to find a different way to invest that money if the company cannot grow earnings internally

I’m not sure that either is realistic given the economy of the last 20 years or so.

Greg
Greg
9 years ago

As many have said above, there is no crystal ball, and stocks could well tank or take off from here. Stocks should only comprise a portion of your portfolio, and you should only invest in stocks if you are comfortable with a loss of 30% or more of your principal (without heading for the exits). I recommend taking a good hard look at your risk tolerance and using that as a guide post. I also recommend that you check Harry Browne’s 16 Rules (http://harrybrowne.org/articles/InvestmentRules.htm) for some (in my opinion) very wise rules about understanding the difference between speculating. BTW, it… Read more »

Budgeting in the Fun Stuff
Budgeting in the Fun Stuff
9 years ago

Loved the pun.

My husband agrees with you 100% and is slowly winning me over. He’s investing $2500 or more a year in high dividend, solid growth “stalks” and holding. The dividends are keeping up with our losses since we didn’t really start until 2009. If our stalks hold up and rebound eventually, we’ll have successfully bought them at a discount and rake it in. If they don’t, at least we have the dividends.

We’ll see how it works out. 🙂

Courtney
Courtney
9 years ago

@ Daniel #17 – I don’t think your statement “The tax rate for capital gains is higher than that for dividends.” is correct. Dividends are taxed as income in the year you receive them, regardless of if they are distributed or reinvested. The rate is equivalent to your income tax rate. Short term capital gains are also taxed at your ordinary income tax rate. Long term capital gains, which is likely the category that Elisabeth’s investments fall into, are due to be taxed beginning in 2011 at a rate between 8-20% depending on how long the investments have been held… Read more »

numpadninja
numpadninja
9 years ago

@Courtney: “Dividends are taxed as income in the year you receive them, regardless of if they are distributed or reinvested.” qualified dividends (such as the kind you’d receive from a mutal fund) are taxed at a lower rate. in the past the top qualified dividend rate was 15%. the current long-term capital gain tax rate is 15%. i.e. you’d be paying the same rate if income was distributed as a dividend or kept in retained earnings (and thus increasing the share price). under this system, capital gains would have been (slightly) more favorable due to the ability to delay tax… Read more »

Courtney
Courtney
9 years ago

@numpadninja – I’d never heard of a qualified dividend, and apparently have never received one either so I can’t really tell what the criteria to meet the qualifications are. Regardless, I still do not see any time where the tax rate for long term capital gains was higher than for dividends (qualified or otherwise). At worst you would be breaking even tax-wise.

chacha1
chacha1
9 years ago

I’ve said it before and I’ll say it again … the only guaranteed way to earn money on investments is to PUT money in investments.

My 401(k) looks pretty good, but that is mostly because I always put enough in to qualify for company matches and profit-sharing – not because of market returns.

Those who have that benefit available and are not using it are probably going to regret it later.

AC
AC
9 years ago

I agree with Greg’s post in that I feel this article is selling the stock market. There are other dividend paying money vehicles out there that were not mentioned. If you want a balanced article, why not touch up on those other methods such as dividend paying whole life insurance? the gains from a life insurance policy are tax free.

Ely
Ely
9 years ago

@ Courtney, “qualified” dividends were invented by the last administration, and they ARE taxed at a lower rate. Details available only from your friendly neighborhood tax professional; no one else understands them. 🙂

@ AC, last time JD put up an article about life insurance, everyone whined about him “selling” life insurance. When will you people learn to take what you want from a post and ignore the rest??

Rosa
Rosa
9 years ago

Financial Samurai, I’ll come clean – we just got a bunch of quarterly statements and we’re just breaking even this year.

Courtney
Courtney
9 years ago

@ Ely, according to Wikipedia the tax rate for “qualified” dividends is the same as for long-term capital gains. They may be taxed at a lower rate than “unqualified” dividends, but they are not taxed at a lower rate than capital gains if you’ve held the shares for more than a year (which I assume is the case for Elisabeth) and thus Daniel’s statement in post #17 does not appear to be correct. I almost wonder if it was a typo because his statement that “The tax rate for capital gains is higher than that for dividends” seems to be… Read more »

SaraBee
SaraBee
9 years ago

I am so tired of people touting stocks. It is gambling, period. You are not investing in a company, anymore than you are a Ford customer when you buy your Escort from your neighbor. The market is manipulated and depends on the contributions of folks who fall for the hype. These markets, complete with bubbles and crashes, are a gamble. The really evil thing is that in order to save the stock market, we drop interest rates to stimulate growth. The rich and powerful take what they want; but there is no Nate Ford and crew to take it back… Read more »

"Unsophisticated" Trader
"Unsophisticated" Trader
8 years ago
Reply to  SaraBee

Every thing’s a gamble.

Some gambles are more successful than others. The chances of ants existing on Earth for the next 6000 years are pretty high. The chances of humans lasting that long? Not as much.

It’s not luck so much as statistics. Everything is a percentage and nothing is absolute. For all you know, this is a T.V. show and you’re the main character.

Budgeting in the Fun Stuff
Budgeting in the Fun Stuff
9 years ago

SaraBee, I don’t know what to say about the doom and gloom mentality, but I love the Leverage reference!!!

Project Management Tools That Work (Bruce)
Project Management Tools That Work (Bruce)
9 years ago

How often do we see someone say “the market is no good” and they compare the last peak in the market to today’s low? How useful is that? Pay attention to the long term average trend, not the highs and lows (which also helps us avoid jumping in and out). How is our portfolio doing relative to our long term planning? We do have a long term plan, yes? Something with assumptions such as an 8% long term growth with maybe 3% inflation? The other often stated phrase is something line “we are still 50% below the last peak!” Who… Read more »

Financial bondage
Financial bondage
9 years ago

Buying individual stocks is a bad idea, according to the man, Dave Ramsey. Mutual funds are better.

Kyle
Kyle
9 years ago

@ #39

Whats even better is buying the individual stocks a mutual or index fund your interested in is tracking. That way you cut down on your fees since you won’t be charging yourself management fees. Its more work on your part since you’ll have to readjust your portfolio occasionally but what you save in fees should be well worth it.

dak9779
dak9779
9 years ago

This is a joke. The investments are denominated in dollars. Therefore you are assuming that the dollar is the same value throughout the investment. In reality, it is not. You have to account for the value appreciation (delfation) or the value depreciation (inflation). If you take the government’s inflation calculator, you will find that the stock market over the long term has return a gain of 0%. Good luck with your stocks!

Chris
Chris
9 years ago

Thanks for this post. I’ve followed the conventional wisdon for my 403B (similar to 401k) with a somewhat more conservative mix than recomended and I’m ok but not nearly where the mutual fund companies said I should be with this strategy. I’ve been wondering if the volatility of the current situation meand we should rethink how much we have in stock funds. Your article helped me to see why I’m doing a little better than the S&P -reinvested dividends and small cap and mid-cap funds. Also my small cap and mid cap fund are value funds so I’m not buying… Read more »

"Unsophisticated" Trader
"Unsophisticated" Trader
8 years ago

Mutual funds and 401k’s are a really bad idea. Either open an IRA or a personal investment account (I prefer the latter as I’m not the kind that wants to be rich by the time his liver’s falling out). DO NOT rely on others to invest for you. Not only does the commission make profitability unlikely, but you compound your risk by giving money to someone else. Think about it, who will be more successful? The guy using his own hard-earned money or the guy using someone else’s? On top of motivational factors, individuals can dodge economical bullets much faster… Read more »

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