The new year is fast approaching and investors are dreaming about future returns. They hope that saving today will yield a mountain of wealth in the years to come. Compounding can help make that happen.
It’s easy to underestimate the power of compounding and dividend reinvestment over the long term. To illustrate, I looked at the returns generated by the S&P 500 over the nearly 30 years from the start of 1990 to the start of December, 2019, based on data collected by Professor Robert Shiller.
The S&P 500 gained an average of 7.6 per cent annually over the period not including dividends (capital gains). It gained an average of 9.8 per cent including reinvested dividends (total returns). Those are fine results, but it’s useful to translate them into dollar figures.
A $100,000 investment in the index would have grown to about $891,000 over the period not including dividends. It would have grown to about $1,655,000 with dividend reinvestment. Even a modest difference in growth rates can really add up in dollar terms when compounded over many years. (All of the figures are in U.S. dollars and do not include fees, taxes, or inflation.)
The relative gains highlight the potential benefits of dividend reinvestment. The boost is so compelling that most investors like to use total returns rather than capital gains when studying the market.
It’s a practice that got me thinking about the returns that can be obtained by stock investors in aggregate. The problem is that while some investors can reinvest their dividends, investors as a group can not.
Normally, reinvestment isn’t a huge issue on the individual level because in a big market there are many sellers who will satisfy the demand. But if every investor wanted to reinvest their dividends, there would be no sellers to provide the shares.
The situation is similar to owning half of a private company that pays dividends. You can only reinvest the dividends in the company’s stock when your partner is willing to sell you some of their shares. But then they’d not be able to reinvest their dividends.
Simply put, investors – as a whole – can not earn the market’s total return. They get capital gains plus non-reinvested dividends.
To put the difference that dividend reinvestment can make into perspective, the S&P 500 would have grown $100,000 to nearly $891,000 without dividends over the almost 30-year period mentioned above. It paid roughly $209,000 in dividends over the period for a total of about $1,100,000. That’s equivalent to an average annual return of 8.3 per cent.
It’s a good deal less than the $1,655,000 that would have been obtained when the dividends were reinvested. Not reinvesting the dividends shaved about 1.5 percentage points off the average annual return.
Alternately, if the investor put the cash they received from dividends in a bank account that earned the equivalent of the rate provided by three-month Treasury bills, then the returns would have climbed slightly.
In this case, the dividend component would grow to about $252,000 and, when factored into the index’s capital gain, would result in an average annual return of 8.5 per cent.
The idea that the average investor earns less than the market’s total return is something to keep in mind when setting return expectations or looking at the past returns of the market, index funds and mutual funds more generally. Total returns represent the best-case scenario. Those who are not reinvesting their dividends should lower their long-term return expectations. Matters get worse – and usually much worse – when fees, taxes and inflation are added into the mix.
Fortunately, as a practical matter, investors who want to reinvest their dividends in the big market indexes, mutual funds and liquid stocks can do so easily. They can benefit from compounding their reinvested dividends and are likely to achieve above-average returns in a rising market by doing so.
Norman Rothery, PhD, CFA, is the founder of StingyInvestor.com.