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The power of reinvested dividends

In a world of record low interest rates, dividends have been finally been getting the respect they deserve.

But as rates rise and other fixed income investments become more attractive, investors wonder if it is time to shift focus. Each person makes that decision based on their circumstances, but dividend-paying stocks have a place at the heart of all balanced portfolios.

The power of dividends lies in their effect over time and what they tell you about a company. A history of dividends says a company is financially stable, has confidence in the future and  respects its shareholders by returning cash to them. When a bear market forces share prices down, you can wait for a rebound, while still collecting a payment.

The impact of dividends on your total return can be substantial. An analysis published in 2012  by Guinness Atkinson Funds in the UK, suggests that dividends provide between 30% and 40% of gains in the short and medium-term.

Dividend_power
Source: Bloomberg, Guinness Atkinson Funds, 2011

Guinness Atkinson reviewed the total returns of the 500 companies in the S&P 500 index from 1940 through 2012. They found that for an average holding period of one year, dividends accounted for 27% of total returns. Over 3 years, they accounted for 38% of returns. After 5 years it was 42%.

If dividends are reinvested through Dividend Reinvestment Plans (DRIPs) the returns are supercharged. Albert Einstein called this power of compound interest the Eighth Wonder of the World as the reinvestment gives you dividends on dividends.

The Guinness Atkinson study pointed out that many non-dividend-paying stocks are also excellent performers and there is no one size fits all. Some growth companies pay token dividends, but have strong share appreciation. Some good dividend payers offer modest share price growth. An overly generous dividend yield may indicate a company in trouble.

The authors concluded that an individual’s investment process should start with a plan. The plan will produce the right mix of fixed income investments, stocks, ETFs and mutual funds to build a  portfolio.

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