This post was originally made on May 12, 2006 on a former blog of mine. The numbers below have been updated through December 2007.

Today I just wanted to give you a little nugget to chew on. In the past 20 years or so the yield on the S&P 500 has gradually decreased. Now, there are still LOTS of companies who have increased their dividends more than inflation but as a whole, the yield of the market has decreased. After the JGTRRA Act in 2003 that lowered the tax on dividends, yields have been slowly increasing but they are nowhere near the historical rate of 4% or so.

Why is that important? From 1926 through 2007 the annualized Total Return of the S&P 500 was 10.43%. Of that amount 40.59% came by way of dividend reinvestment. Therefore, only about 59% came by way of capital appreciation (or about 6.2% of the 10.43% total). See the data at Standard and Poor’s (bottom paragraph).

This one simple fact causes me to make several observations.

Another reason you cannot BEAT THE MARKET. As I have said in previous posts, dividends are taxable income. The S&P 500 total returns index does NOT factor in these taxes. When you reinvest dividends you have a tax burden that needs to be factored into your personal total return. If roughly 40% of the returns come from reinvested dividends and your average tax burden is say 25% (the 15% rate on dividends only started in 2003) then you are losing a full percentage point off your returns simply in taxes. There will be detractors who argue that taxes should not be included in these calculations but I beg to differ. If someone has plenty of cash lying around to pay their taxes and reinvests 100% of their dividends that’s one thing, however, many people will use some of their dividend income to pay their taxes thereby reducing the amount they reinvest and by association decreasing their returns. Of course this makes little difference in a non-taxable retirement account.

The short term trader mountain to climb. For the most part, short term traders only make returns via capital appreciation (there are some dividend “gamers” but they are a rare breed). If that is the case, then they must make capital appreciation greater than 10.43% to “beat” the market. That means they must make about 68% more in capital appreciation than the market (10.43-6.2 = 4.23, 4.23/6.2 = 68%) in order to just break even. What are the odds of that happening over an extended period of time? This is why short term traders have to gravitate to growth stocks and momentum plays. Trying to make above average short term capital gains on a stock that gets half its returns from dividends is a losing battle.

Show me the money. As a whole, stocks that pay large dividends are typically mature companies whose future growth pattern does not look very parabolic. In layman’s terms - these stocks are very boring for most people. It would behoove most of us to pay closer attention to dividends. For starters, it’s hard to “fake” a dividend payment. Given the recent environment of corporate scandal and the misrepresentation of earnings, dividends make one feel a bit safer. Since the yield of the market has decreased, if we are to continue our 10.43% drift into the future then the growth premium will have to be higher than it has been historically (and it certainly has been high the last 3 years). The one thing I am cautious of is that “growth” is inherently a moving target and very volatile. Growth contains a lot of fluff. Growth contains a lot of predictions from a lot of people. Growth is very chaotic. If we continue to expect high returns based strictly on growth we are certain to experience wild swings in our returns.

I am a big fan of dividends despite their lack of entertainment value. I will be writing further about the strengths and weaknesses of portfolios heavy in yield. For now I just wanted to share that little fact with you. The next time one of your friends hypes his favorite growth stock just ask him where the other 40% of his gains is going to come from. If he says another growth stock then he may have some issues.

“Do you know the only thing that gives me pleasure? It’s to see my dividends coming in.” -John D. Rockefeller

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