Not too long ago, I was asked to guest lecture a first year MBA class on investing. I began by asking the students how much of their work over the semester focused on dividends. As I turned to the chalkboard to write down some of the answers, one of the students offered up: “less than zero!” Other members of the class nodded in agreement, and so on the board I wrote: “Dividends = Less Than Zero.”
The student who offered up this answer explained that in addition to having very little course work on dividends, another guest lecturer had commented that dividends were often a negative in his view. Perhaps the dividend meant the company didn’t have enough areas to invest in for future growth? Maybe it limited the return potential of the stock? Was it a sign of a maturing business?
As a strong believer in the power of dividends, I realized I had my work cut out for me. To present a counter-example, I offered up the following hypothetical case to my class (drawing on some numbers from a Ned Davis Research study):
I asked to students to suppose they had a grandmother who at age 10 received a gift of $100 invested in the S&P 500 Index in 1930. Let’s also suppose that this grandmother travels in time to the present day (this is a hypothetical after all!), comes into our classroom and sees our chalkboard with the words “Dividends = Less Than Zero.” Upon seeing this, she returns back to 1930. With her newfound insight into what the MBAs of the future are learning, she decides that the best strategy is to leave the principal invested and just use whatever dividends she receives for some extra spending money. Following this strategy, by 2010 her $100 would have grown to a significantly larger $5,863.
I then asked the students to imagine the same scenario. Only in this case, the grandmother doesn’t travel in time and never gets to read our chalkboard. Without the supposed benefit of seeing our chalkboard, she decides to go ahead and simply reinvest the dividends instead of spending them. How much does this seemingly small different make? Following this strategy, by 2010 her $100 would have grown to $142,045, roughly 24x the $5,863 in the first example.
How can there be such a vast difference between the two numbers? The first case shows only the impact of price appreciation on the original investment. The second case includes all the dividends received and the additional price appreciation on the shares purchased by reinvesting those dividends. I should also note that both cases don’t account for the impact of taxes.
Obviously, the two cases are not directly comparable, as she was able to spend the dividends in the first case and not the second, but difference demonstrates just how powerful the compounding effect of dividend reinvestment can be. While the students in my class have a lifetime ahead of them to have these factors work in their favor, all investors with a longer-term time horizon have the ability to harness this powerful impact as well.