Dividends create wealth

by Nick on August 31, 2010

Every once in a while I catch Jim Cramer’s Mad Money on CNBC.  I actually like the show quite a bit because I enjoy “stock talk” and he’s pretty much the only one who makes it entertaining (I like Fast Money’s stock talk a little more, but Cramer has a higher entertainment value.).

When I miss the show I sometimes check out the Mad Cap Recap to see if there was anything interesting that I missed.  Yesterday was one of those times.  And it turns out that there was certainly something interesting that I missed.  The data referenced is nothing that hasn’t been reported in other places, but I figured it was good to mention here.  So let’s cut right to what Mr. Cramer had to say this time around.

Dividends create wealth.  I agree.  Dividend reinvesting is a great way to build up a sizable investment account, whether it is by owning stocks, ETFs or mutual funds that pay dividends and then telling your broker to automatically reinvest all dividends by buying more shares.  Many discount brokers have a system that allows you to “opt-in” and automatically buy shares (and fractional shares) when you receive a dividend.  And you can usually indicate what securities you want the opt-in to apply to (or you can go “all in”).

I opted in (all in!) with TD Ameritrade.  It was easy – I did it all on e-mail within TD Ameritrade’s website.  At first it’s “pretty cool” to see your dividends issued and then your number of shares go up.  A couple of years later it’s “very cool” to see how many more shares you get each time.

Why is this so great?  It’s similar to employer matching on a 401(k) (not exactly the same but stick with me for a second).  You buy a stock.  That stock pays a dividend.  Then the amount of the dividend buys more stock.  Three months later the stock pays a dividend again.  This time you own more stock because you used your dividend to buy more shares last time (and those shares pay a dividend this time, too).  And next time you will have even more shares.  Those “bonus” shares are the gifts that keep on giving.  Your dividends will start paying dividends!  And you can participate in the stock or fund price movements (hopefully up…).  Which brings me to my next point:

Don’t just do a search for “highest yielding stocks, mutual funds or ETFs” and buy the top ten just because of the yield.  That is not a good idea.  It is common for struggling companies to cut or suspend their dividends.  The high yield could indicate the company is in bad financial shape.  If that’s the case, the stock price may have plummeted and the dividend cut is just a matter of time.  The point is, pick companies, mutual funds or ETFs that you understand and believe in, which pay a nice, safe dividend.  Then reinvesting your dividends can supercharge your investment account.  There are plenty of thse stocks, mutual funds and ETFs out there now.

Two more takeaways from the Mad Cap Recap:

  • Between 1926 and now, about 40% of the total return of the S&P; 500 came from reinvested dividends, meaning the cash distribution from a particular stock was immediately used to buy more of that stock; and
  • Jeremy Siegel, a well-regarded economist and noted professor at the Wharton School of the University of Pennsylvania, reviewed all the data between 1957 and 2009 and found that the 100 stocks in the S&P; 500 with the highest dividends returned an average of 12.5% a year, almost 2.5% better than the annual return of the index as a whole;

Pretty interesting stuff.  The second one reminds me of this investment strategy.  I’ve been looking at the Dogs of the Dow strategy for a little while and it’s certainly interesting.  But, again, I’m not a big believer in picking stocks just because of the yield, so it’s not a strategy I would blindly employ.

One more thing – I also would not read the article to be advising not to invest in bonds (even though it really does seem to push high-yielding stocks at the expense of bonds). 

Like I wrote about before, bonds are an important part of most portfolios.  They have different risk profiles, to I don’t like the idea of using high-yielding stocks as a substitute for bonds.  But if you find stocks, mutual funds or ETFs that you believe in and happen to pay a nice dividend (I like to see a 4% yield or higher these days), you should consider those for the stock portion of your investment portfolio.  History seems to agree with that approach, for what it’s worth.  But don’t ignore bonds!  They’ll help you sleep at night on the rough days, months or years.

And, of course, put the credit card down and slowly step away from the mall!

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