How dividends work, add to stock returns: chief investment strategist

It’s been a volatile and difficult year for investors in the broader stock market, and tech stock investors have had it even worse. However, if you’re investing in dividend stocks, you’re probably doing a little better.

There’s a good reason for that, says Sam Stovall, chief investment strategist at CFRA Research. “Dividend stocks reduce overall volatility,” he says. “Dividend payments provide a cushion to offset price declines.”

Case in point: The S&P 500, a measure of the broad stock market, is down about 16% so far in 2022. An index that tracks technology stocks in the S&P 500 is down about 23% year over year and is still solidly in bear territory — defined as a decline of 20% or more from recent highs.

The FTSE High Dividend Yield Index, which tracks the returns of large and medium-sized companies that pay the highest dividends relative to their share prices, is down just over 5% year-on-year.

But dividend stocks aren’t just handy when the going gets tough. Stovall notes that since 1945, reinvested dividends have contributed 33% to the S&P 500’s total return.

“Essentially, dividends can improve your performance by a third without doing anything,” he says. “You can add more octane to your performance simply by owning dividend stocks.”

Even if you didn’t know it, you probably already own some dividend stocks. About 400 stocks in the S&P 500 pay one.

Here’s how it works. When a company makes excess profits, it has a number of choices about how to use the money. It could reinvest in the business, for example by opening new stores or funding research for new product lines.

But many companies — particularly large, financially mature ones — choose to return some of that money back to shareholders as a sort of “thank you, please stick with it.” These periodic cash payments are a stock’s dividend.

Investors also have a choice when it comes to dividends. If you are retired, you can use this cash payment as pocket money. For younger, long-term investors, the usual move is to reinvest the dividend back into your portfolio.

To understand how this can boost your investment performance, calculate a stock’s dividend yield by dividing the amount of cash you receive annually from a single stock by the stock price. If you own a stock that’s worth $50 per share and you’re paid $1 for every share you own, that stock yields 2%.

By adding this dividend yield to a stock’s price yield — the percentage it moves up or down in the stock price — you find the total return you get on an investment. If your stock is up 10% and down 2%, you’ve earned a 12% return on your investment.

If the same stock falls 5%, that 2% payout brings your total return to 3%.

Stovall’s 33% figure represents the difference between the S&P 500’s price return and its total return since 1945. In recent years, the difference has been more pronounced: Since 1988, the S&P 500 has risen a cumulative 1,455% in price, according to FactSet data, which means that a $10,000 investment would now be worth $155,500.

Add in reinvested dividends and you can see how compound interest affects the extra money. Factoring in total returns, $10,000 would now be worth $329,300. That means dividends accounted for a whopping 68% of the broad market’s total return during that period.

If you’re not already reinvesting dividends into your portfolio, you can set up automatic reinvestment through almost any online brokerage account. If you own a fund that tracks the S&P 500, you’re adding the index’s 1.6% total return to your return.

If you’re looking to further increase your stock portfolio’s returns, you can invest in one of the many mutual funds and exchange-traded funds that focus on dividend payers. These generally come in two flavors: funds that focus on high-yielding stocks, and strategies that invest in companies that are steadily increasing their payouts.

The former is better suited for investors looking for some baggage in a choppy market, says Todd Rosenbluth, head of research at investment analysis firm VettaFi: “Companies that pay above-average yields tend to hold up better when markets are sold out. This protection against losses offers you returns.”

For those looking to increase their long-term returns, dividend growth funds are a better fit.

“A company will only increase its dividend if management has confidence in the company’s long-term prospects,” says Rosenbluth. “These stocks will have a greater opportunity [than higher yielders] to keep pace with the broader market, but still offer higher returns than the broader market.”

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