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Time Is On Your Side
Sure, when you’re starting out, or in a hurry to accumulate some wealth, collecting a few percent on your cash hardly seems worth it. But consider the alternatives. Namely, interest bearing savings accounts and bond yields remain well below their historical norms. But the key here is the magic of compounding. Let’s take a look at a pure example, where everything else stays equal (though it inconveniently never does). A 2% dividend yield on a $10,000 stock investment will generate a payout of $200 a year.  That’s not exactly a whole lot to get excited about, honestly, especially since stocks can gyrate that much on any given day. But, if we put that back in, buying more shares, we now have $10,200 earning a 2% yield. Wait another year, and we collect checks for $204. Lather, rinse, and repeat, and the third year we rake in $208, lifting our account to $10,612 and change.

Of course, most companies pay a quarterly dividend, so the compounding would come slightly faster. On top of that, you’d likely be adding to your account on occasion, allowing the compounding to accelerate its magic.

But let’s say you didn’t, and you just let your $10,000 sit somewhere earning a constant rate of 2% (preferably more). After 10 years of faithful patience, and annual compounding, you’ve now amassed a tidy sum of $12,190, or thereabouts, for a total return of 21.9%

Still doesn’t sound like much, compared to potential stock gains. But what if we combined the two? For that, let’s step out of the realm of theory and look at some real world examples.

The Numbers Speak
Although recent periods have proven otherwise, stock values generally tend to rise over time. This reflects companies expanding and earning more, as well as the effects of inflation.

But walk up to the average man or woman on the street and tell them that, over time, dividends account for a large portion of long-term investment returns, and chances are he or she will look at you dumbfounded. And yet, those small payments gradually begin to build, and then eventually snowball.

We’ve all seen examples of how if you had invested a dollar when Abe Lincoln was President, you’d be quite well off by now. But it’s doubtful you’d be dancing out in the streets about it, considering you’d be the oldest investor alive. What about a more up-to-date illustration, or at least one within memorable history.

Well, setting our clocks back to 1980, and assuming we had put $10,000 worth of our hard-earned dollars into the S&P 500 Index in January of that year and “let it ride” until December of 2010, we’d have accumulated ourselves a nifty sum of nearly $113,000. Not bad. This works out to an annual rate of return in the neighborhood of 8.1%. This assumes that any dividends received were pocketed along the way.

But wait. If you had reinvested those dividends, you would have cleared an average of around 3% more a year, or 11.2% annually.  That doesn’t sound like much, you say—a measly 3% multiplied by 30 years is what, 90% more? You made more than 10 times your original investment by spending the dividends. Why be greedy and go for another “bagger” extra.

Well, here’s where the magic of compounding does its thing. That little extra 3% doesn’t earn you another $10,000. Instead, it would have translated into nearly $163,000 extra, for a grand sum of over $265,000.

Good Times, Bad Times
Of course, the example above includes the greatest extended stock market advance ever known to man. It also includes a couple of more recent blowups. To be sure, dividend reinvesting is no sure-fire cure to avoid taking losses in the game of long-term investing. However, it can still make a big difference.

So what happens when you don’t invest at the start of a great bull market, and just happen to commit the common investor error of less-than-perfect timing? Well, going back to the S&P again, because it offers a fairly broad overview of the market, let’s take a look at what happened if you got in at the top. January 2000 is a fairly clean place to start, just before the market averages called it quits at the peak of the tech bubble. 

From January 2000 through January of 2010, the S&P posted one of its rare losing periods, falling from 1425 to 1242 over that challenging decade. In total, the loss was about 13%, which works out to an annual decline of around 1.25% per year.  A $10,000 stake at the beginning would have declined to about $8,700. Not a pretty picture. But once we factor in regularly buying more shares with the dividends that were paid out, the picture brightens considerably. The annual rate of return would have been a less-than-inspiring 0.55%. However, that would mean a total profit of over $622 instead of a loss. Bottom line, having $10,622 in your account instead of $8,700 makes for a huge difference in overall return.

Making It Automatic
Let’s face it, the majority of investors who are not professional traders tend to move in and out based on emotions. The tendency, of course, is to get pumped up when stocks are rising and jump in just when the crowd is biggest, usually right at the top of the market. Then, the natural reaction is to bail out at the bottom, when one really ought to be backing up the proverbial truck to buy up everything on sale.  The best way to avoid getting swept up in the emotions generated by stock price gyrations (and related attempts at market timing) is to reinvest dividends on a regular basis.

One of the most popular ways to do this is through Dividend Reinvestment Plans (DRIPs).  That is, many companies offer programs whereby they will do all the work for you, regularly buying more shares with the dividends earned. For one thing, such plans make it easier to stay disciplined. They also often lower your costs considerably, as you get to sidestep most or all broker transaction costs. The latter point is even more important if you’re just starting out with a relatively small sum. An even better deal can be had from those companies that offer their stock at a discount from market prices. In the footnotes of the every Value Line Ratings and Reports page, we indicate which companies have DRIP plans available.

Regular brokers will often have some sort of sweep account or similar setup available whereby dividends can be plowed back into more stock shares, but it’s best to check first to see if commissions are involved. For those investors that don’t like to dabble in individual stocks or bonds, the vast majority of mutual funds also offer an automatic reinvestment service.

As an added bonus to using these methods, you also get some of the benefits of dollar cost averaging. That is, you’re adding to your holdings on a regular basis, whether the market is up or down. But the key is that you force yourself to buy more shares when stocks head south, and fewer when prices skyrocket, which is often difficult to do from an emotional standpoint.

There are further steps one can take to refine this strategy, of course. For example, it’s usually best to stay with solid, established companies with long records of regular dividend increases.  These would include such household names as Coca-Cola (KO – Free Coca-Cola Stock Report), Colgate-Palmolive (CL), McDonald’s (MCD – Free McDonald’s Stock Report), and Johnson & Johnson (JNJ – Free Johnson & Johnson Stock Report). By the same token, high dividend yields should be avoided, as they often indicate trouble ahead for the issuing company.

Overall, long-term success in the buy and hold arena requires a steady hand, and staying the course is a lot easier with the compounded earning power provided by reinvested dividends.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.