A young investor is often tempted to invest in a highflier tech IPO than a steady firm to get a greater return and capital appreciation on their investment. If a great return is not the answer, then why invest? Albert Einstein partially answered this question by saying that compound interest was the greatest discovery of mathematics; this leads us to the basics of investing that most of stock market returns come from dividends and dividend growth. Clearly, young investors should look beyond short-term investment gains for dividend returns because the total return from a stock is a combination of price return and dividend return.
Individual investors seem to underperform, relative to benchmark indices, in equity markets. On the basis of Fama–French’s three-factor model, individual investors most focused on capturing price gains underperform by an average of 54 basis points per month relative to a total return benchmark index (value-weighted index of NYSE/AMEX/Nasdaq stocks). A research that analyzed trade statistics in the Taiwan Stock Exchange during 1995–1999 observed that individual investors recorded an annual underperformance of 3.8 percentage points compared to passive investor in TAIEX (a value-weighted index of all listed securities). A study by Morningstar showed that a typical investor in funds registered a 4.8% annualized return, compared with 7.3% for a typical fund over the 10 years 2013; the primary reason for fund’s better performance was because it stayed invested while the investor moved in and out of the investment during the period of the study.
So while young investors follow equity price movements to increase returns, these research statistics point that their actions are not aligned to their objective.
Debugging the dividend myth
In investment parlance, when a company starts paying dividends, it has a positive impact on its stock value. A growing dividend is a further boost. This also reflects that the company has stabilized its earnings and cash flows which is a good sign for stable returns and for long-term investment.
In fact, research shows that, over the long term, reinvested dividends are a major contributor to total returns. For example, in the period December 1994–October 2017, 40% of the total return of the S&P 500 Index can be attributed to reinvested dividends and the power of compounding.
Taking advantage of dividend stocks
Can you estimate the next crash of a stock market? If a stock market crashes, the first blow comes to the hyped-stocks or short-term highflier stocks, which crash with a thud. On the other hand, dividend growth stocks are likely to hold ground, being low-risk and consistently paying increasing amounts of dividend. A study by Ned Davis shows that, over the 45 years from 1972 to 2017, those S&P 500 Index constituents that began paying dividends, or increased them, had a higher average annual return than firms who reduced, maintained or eliminated their dividends, or never paid one at all. Another interesting research conducted by Reality Shares shows that among dividend-growth stocks, the degree of dividend growth matters. Total return of a stock and its dividend growth are positively correlated. Therefore, for better long term yield and higher stock returns, young investors should focus on investing in high-dividend growth stocks early on.
Read our whitepaper for more topic related insights: Why dividends matter for young investors (too).