If something is said to ‘pay dividends’ then it’s generally understood to benefit in some way. It’s an apt phrase when it comes to investing in shares, where the word ‘dividends’ more precisely refers to the regular payments many companies make to shareholders from their profits.

When reinvested and added to capital gains, dividends make up a portion of an investor’s ‘total return’ – and, as such, can have a major influence on their eventual success.

This is because company dividends play a crucial role driving long-term returns. Take the US stock market, which has traditionally been seen as more growth-led and, therefore, comprised of relatively more companies that choose to reinvest their profits in their businesses.

The chart below highlights the importance of dividends when compounded1 over a very long horizon for the S&P 500 index. To capture the full extent of the growth in just one snapshot, we’ve used a log scale2.

Although past performance is no guarantee of future performance, it’s probably fair to say that the historical contribution of dividends shown will surprise a lot of people.

Contribution of dividends to historical long-term US stock market total returns

Past performance is not a reliable indicator of future returns.

Source: Robert J. Shiller, with stock market data used in "Irrational Exuberance" Princeton University Press, 2000, 2005, 2015, Vanguard. Data from 31 October 1922 to 31 October 2022 and based on S&P 500 index. Dividends are gross (i.e. without accounting for withholding tax) and are reinvested into the index. Total and price returns are in US dollars.

The chart above goes back 100 years, so the outsized impact reflects the constant compounding of those dividend payments.

However, even if we choose a shorter timeframe, we can see just how important those dividends can be relative to capital growth. For example, over the 20 years to 31 October 2022, 39% of the total returns generated by the S&P 500 index was derived from reinvested dividends3.

What about in the UK?

In the UK, the role of dividends has historically been more prominent, partly because companies here have traditionally maintained generous payout policies to accommodate certain institutional shareholders (such as pension funds and life insurers) who prize long-term income more than other types of investors.

It’s why our research shows that reinvested dividends made up 67% of total returns over the same 20-year period4.

The flipside is that fewer profits have tended to be reinvested by UK businesses, limiting the potential for capital growth and contributing to the UK stock market’s relatively weaker performance over the long term.

Inflation-proofing qualities

One reason why having a diversified exposure to dividends can be so powerful in generating returns is their historical propensity to beat inflation.

In the US, for instance, annualised dividend growth outpaced inflation by five percentage points in the 20 years to 30 October 2022 and by 2.1 percentage points over 100 years, as the chart shows.

Annualised growth of US dividends and inflation

Past performance is not a reliable indicator of future returns.

Source: Robert J. Shiller, with stock market data used in "Irrational Exuberance" Princeton University Press, 2000, 2005, 2015, Vanguard. Data from 30 September 1922 to 30 October 2022. Dividends per share are for the S&P 500 index. Inflation = US Urban Consumer Index

While the inflation-adjusted growth of dividends in the UK has been less stellar in comparison, dividend growth has nevertheless outstripped price growth by 0.6 percentage points over the same 20-year time horizon5.

Over the long term, even modest real growth in dividends can compound significantly if reinvested.

For investors looking to generate a positive real return over a very long horizon, shares – especially if globally diversified – provide the best probability of beating inflation.

Dividends, in turn, can offer a significant boost to an investor’s total returns, especially if re-invested and allowed to compound over time.

Even during downturns, when they may be cut in some instances, they can also be reinvested at discounted valuations, which can amplify the compounding and boost long-run total returns once the market rebounds. And the longer the investment horizon, the greater this potential snowballing effect of dividends on total returns.

If you’re investing for long-term growth, it’s more reason to consider investing in ‘accumulation’ funds that automatically reinvest dividends for you. 

 

1  (For more on what compounding means, read our guide).
2 The vertical axis does not increase in equal increments. Instead, each interval rises by a factor of 10.
3 Source: Robert J. Shiller, with stock market data used in "Irrational Exuberance" Princeton University Press, 2000, 2005, 2015, Vanguard. Data from 31 October 1922 to 31 October 2022. Dividends are gross (i.e. without accounting for withholding tax) and are reinvested into the index. Total and price returns are in US dollars.
4 Source: Bloomberg, ONS, GFD. Data from 30 October 2002 to 31 October 2022. Dividends are gross (i.e. without accounting for withholding tax) and are reinvested into the index. Total and price returns are for the FT Actuaries All-Share Index and chain linked within the FTSE All Share Index, in GBP.
5 Source: Bloomberg, ONS, GFD, Vanguard. Data from 30 October 1922 to 31 October 2022. Dividends per share are of the FT Actuaries All Share Index and chain linked with FTSE All Share Index Inflation = UK CPI index.

 

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