Focus on an Investment's Total Return Not Capital Gains
Don't Join the Capital Gains Cult - Stock Price Alone Isn't the Whole Picture
One of the most frustrating things I experience as a professional is encountering new investors who lament the fact that a stock they own hasn’t generated substantial capital gains by increasing in market price over several years. Yet, if you asked them the total cash dividend return they had earned during the same time period, it is likely they would give you a blank look. (As you have already learned in the beginner’s guide to dividends, dividends represent part of a company’s profit that is paid out to stockholders, who are the owners.
They are declared by the Board of Directors and the total percentage of the profit that is paid out is known as the dividend payout ratio. Companies that are older, more mature, and don’t have as many opportunities for expansion likely have higher dividend payout ratios than those that are young, small, and fast growing.)
An illustration may help underscore my point. Imagine you were a partner in a private manufacturing business and your shares were valued at $500,000. For ten years, you hold on to this stock and the value never increases, yet during this same time period, you receive $1,500,000 in cash dividends. Obviously, this has been a great investment and you should be thrilled. Every year, you receive substantial checks in the mail as a result of your ownership. However, if you were to listen to the media, or look at a stock chart, you would consider your investment a total failure.
Why? The financial media doesn’t include the total dividends received in determining the return shareholders have earned by owning a stock. In fact, in this case, your stock chart would show a flat line, leading many new investors to believe you had actually lost money after inflation over the decade you held your shares.
(On my personal blog, I explained the three things stock chart providers should include to drastically increase their accuracy for long-term investors were they so inclined to do so.)
I believe this oversight is professional malpractice. Can you imagine going to a doctor who didn’t know how to read an X-Ray? The tragedy is that this phenomenon is relatively new. Up until the great bull market that began in the 1980s, it was said that the purpose of a company was to pay dividends, which forced a focus on total return rather than capital gains alone. With people addicted to the pursuit of overnight riches and a gambling culture, it became much easier to envision yourself buying a stock and watching it go to the moon rather than buying a stock and slowly collecting cash along with underlying appreciation.
If you need evidence this mindset pervades even the financial media consider this: A rather common mistake made by journalist is to point out that it took more than twenty years for the stock market to reach its former peak level after the Great Depression. Yet, several financial studies have shown that an investor who took advantage of disciplined dollar cost averaging and reinvested his or her dividends actually broke even in as little as 5-7 years, and by the time the market had returned to its former level, made an absolute mint.
This is due to something that Dr. Jeremy Siegel at Wharton University referred to as the "bear market accelerator" effect, which I discussed in a post about investing in the oil majors.
Why This Focus on Total Return and Not Capital Gains Should Matter to You
Most of the biggest companies in the world pay out a substantial, if not majority, of the annual profit generated from operations in the form of a cash dividend. Firms such as Johnson & Johnson, Coca-Cola, General Electric, Apple, Exxon Mobil, Nestle, United Technologies, McDonald's, and The Walt Disney Company often return the money earned throughout the year to stockholders in the form of cash dividends and share repurchase programs. In Why Boring Is Almost Always More Profitable, I discussed the work of the aforementioned Dr. Jeremy Siegel, who showed that 99% of the real, inflation-adjusted return investors earn is the result of reinvesting their dividends, especially on quality firms such as these.
That means that if you own blue chip stocks, you don’t need share prices to increase very much before you begin growing wealthier.
The implications for the average investor are clear: If you own an index fund that invests based on the S&P 500 or Dow Jones Industrial Average, most of your money is going to be put to work in companies with substantial dividend distributions. That means that a material percentage of your long-term return is going to come from reinvested dividends, not capital gains. It may be about as exciting as watching paint dry, but if you get richer in the end, it shouldn't matter.
Taking the Next Step to Focusing on Total Return
Once you understand the importance of total return, you need to read Calculating Total Return and CAGR. It will explain how you can use some simple algebra to determine the rate of return you earned on an investment during the time you owned it, including the dividends you received. You may also want to read Why Total Return Is More Important Than Changes In Market Capitalization.
Finally, consider checking out Income Investing for Beginners - a 10 Part Guide to Choosing Great Investments That Generate Cash.