The Greatest Investing "Secret"

I've read quite a few investing-related books in my time, but perhaps none has been as surprisingly eye-opening as Jeremy Siegel's The Future for Investors. Siegel shares a great "secret" of accumulating wealth over the long term, and I'll re-share it with you today.

This secret involves the effects of dividend-paying stocks, and why not owning some could cost you dearly and delay your retirement for years.

Why dividends matter
Most people are aware of at least some of the power of dividends. For example, studies conducted by Siegel and others show that higher-dividend-yielding stocks tend to offer higher returns over time than do low- or no-yield stocks. Others will point to the legitimacy that dividends lend to a company's earnings. You can't fake the real cash paid out in dividends, so we therefore don't have to place total trust in management's earnings reports.

While I was aware of these particular advantages, I didn't realize just how powerful dividends are until reading Siegel. In his book, he points out a few facts regarding the reinvestment of these seemingly small sums. During his study period of 1871 to 2003, he found that "97% of the total after-inflation accumulation from stocks comes from reinvesting dividends. Only 3% comes from capital gains." The fact that dividends, in one form or another, make up 97% of historical returns is one big reason you should consider dividend-payers for your portfolio.

Depressions are good for you
But perhaps the greatest single example of the power of dividends involves the stock market crash of 1929 and the Great Depression that followed. On Sept. 3, 1929, the Dow Jones Industrial Average hit 381 -- and it did not reach that level again until November 1954. That's an incredible peak to trough to peak that pained investors for a full 25 years.

If you'd known that was coming, you would surely have been better off dumping your stocks and getting into bonds or treasuries, right? Wrong ... very wrong.

According to Siegel, the average stockholder who reinvested his or her dividends actually showed an annual rate of return of more than 6% during that 25-year period. That's about twice the accumulation of bonds and four times better than short-term treasuries.

In fact, Siegel points out that if the Great Depression had never occurred, and if dividends had made a smooth ascent while stock prices remained stable, things would actually have been far worse for long-term stock investors. Consider: $1,000 invested at the beginning of this fictional, stable period would have turned into only $2,720 by November 1954, 60% less than what investors actually accumulated in real life. Why?

Bear-market protector and return accelerator
Dividend yield is a huge factor when it comes to actual returns. (A one-sentence primer: a $100 stock that pays $2 in yearly dividends has a yield of 2%.) And although dividends declined 55% from their 1929 peak, stock prices fell even more, meaning dividend yields during the Depression actually increased. And as investors reinvested those dividends, the extra shares purchased at depressed prices caused returns to rocket ahead when stock prices finally recovered.

The important lesson here, according to Siegel: "Market cycles, although difficult on investors' psyches, generate wealth for long-term stockholders. These gains come not through timing the market but through reinvestment of dividends."

So, Siegel says, the extra shares purchased and accumulated during down periods act as a bear-market protector, and these extra shares rising in value turn into a "return accelerator" when prices rise.

For a final bit of proof, consider that the 20 best-performing survivor stocks from the original S&P 500 in 1957 are all dividend-payers. Here is a small sampling of these "corporate El Dorados," as Siegel calls them, and their 1957 to 2003 returns (dividends reinvested, of course):

Source: Jeremy Siegel, The Future for Investors.

Be an Income Investor
I hope this column convinces you of the importance of owning some dividend-paying stocks, and of reinvesting those dividends. Doing so can give you some peace of mind during rough markets, as you'll feel cushioned by the extra shares you've accumulated, and your returns will accelerate when the market recovers.

What's your next step? I can recommend without hesitation a 30-day free trial to Motley Fool Income Investor, where Mathew Emmert's recommendations have outperformed the market 14.5% to 8% -- dividends reinvested, of course. The companies he presents monthly could be just the boost your portfolio needs. Click here for more information.

Rex Moore is a research analyst for the Fool and a hopeful Cardinals fan. At press time, he owned shares of Procter & Gamble. Merck is a Motley Fool Income Investor recommendation. For more on our disclosure policy,click here.