How the Dow Makes Money for You

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At the end of the day, investors want their stocks to produce big returns. As long as you don't need any income along the way, it doesn't really matter whether those returns come from dividends or from stock-price appreciation -- as soon as you sell, you'll reap the same rewards.

During the so-called "lost decade" of the 2000s, however, many investors started looking a lot more closely at dividends as the primary driver of total return. When stock prices stayed flat or fell even over long periods of time, dividends seemed like the only way that you could expect to eke out any return at all from your investments.

But are dividends really the key to total returns? A look at the stocks in the Dow Jones Industrials (INDEX: ^DJI  ) will give us some insight into exactly how much of the 30 Dow stocks' returns came from capital gains versus dividends.

The overall picture
When you look at the Dow as a whole, you have to remember that the average itself doesn't take dividends into account. Therefore, if you just compare the closing value of the Dow today versus what it was 10 years ago, you'd come up with a rise of about 30% -- but that doesn't include dividend income at all. The total return of a Dow-tracking ETF gives you a more accurate view, showing a rise of roughly twice that figure.

Looking at the overall distribution of 30 Dow stocks shows roughly the same impact from dividends and capital gains. The average Dow stock has seen its price rise by 42% over the past 10 years. When you add in the effect of dividends, though, the average total return goes up to 83% -- suggesting a very simple answer that half of returns came from dividends and the other half from capital gains.

Dividend haves and have-nots
If you look more closely at some of the individual Dow stocks, however, you get a much different picture. Consider the following:

  • Among the top-returning stocks, dividends played an important but not equal role in returns. For Caterpillar (NYSE: CAT  ) , a bit more than a quarter of its 361% total return came from dividends, while with McDonald's, the split was closer to 70/30 in favor of capital gains. Caterpillar rose because of its foray into high-growth emerging markets, while McDonald's remade itself into a rejuvenated force in fast food. For both, growth made dividends less significant by comparison.
  • With the worst-performing stocks, dividends weren't able to offset the effect of price declines very well. Alcoa's (NYSE: AA  ) dividends added only 6 percentage points back to its 73% price decline, while Bank of America (NYSE: BAC  ) could improve its total return by only 8 percentage points from its dividends. Both Alcoa and B of A suffered greatly during the recession and market meltdown, and neither has come close to fully recovering.
  • In general, the weaker the total return, the more important dividends were in producing that return.

As examples of that last point, take a look at the most extreme case in the Dow: Verizon (NYSE: VZ  ) . The telecom giant saw a very tiny decline in its share price over the past 10 years. But when you factor in dividends, you see that they produced an 81% total return -- almost enough to bring Verizon back to the Dow's average. AT&T shows the same general phenomenon, with a 6% stock-price rise turning into an 80% total return including dividends. Both show how, with the headwind of huge capital investments holding share prices down, investors can still post decent long-term returns with dividends.

What to take away
These results show that dividends are clearly an important part of the return in any diversified portfolio. Without dividends, some of your weaker-performing investments won't be able to produce any return at all.

But neither are dividends the end-all, be-all of investing. With most of your big winners, capital appreciation will be the big driver of total return, with any dividends a stock may pay being icing on the cake.

When you're trying to decide which stocks to invest in, be sure to look for healthy dividends and the potential for share-price growth. Only the best combination of both factors will give you the extraordinary returns that every investor strives for.

If you're looking for dividend-paying stocks that may fit the bill, look no further. The Motley Fool's special report on dividends will point the way to nine promising stocks for income and capital gains. A free look is just a click away.

Fool contributor Dan Caplinger likes returns any way he can get them. You can follow him on Twitter. The Motley Fool owns shares of Bank of America. Motley Fool newsletter services have recommended buying shares of McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool has a disclosure policy.

Read/Post Comments (2) | Recommend This Article (12)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 06, 2012, at 12:23 PM, rossirina wrote:

    Shouldn't we just pick ETFs and simplify our life with understanding the total return they provide? In my brokerage account I elected to automatically reinvest dividends which is efficient since I don’t need to remember to do it (it's also cheaper than buying small # of shares) but it's harder to measure the total return on the initial investment.

  • Report this Comment On May 07, 2012, at 3:11 AM, Yourdeadmeat69 wrote:

    The DOW is an industrial average reflecting 19th Century thinking, the S and P 500 really reflects, without the DOW 30, the real value of investment.

    The reason for growth in stock markets--the degradation of paper currency since 1971--90% (which is what happens when "inflation", really the disemboweling of our currency via printing money, is 6% a year). We simply borrow year one, and voila, 30 years later, we're paying back debt in the form of dollars worth a dime. Just take us off the silver and gold standard, borrow your brains out, and print payments and principal using printing presses or bonds sold a gullible world.

    Making the Middle East pay for all oil in paper scrip called petro dollars is the only reason why the dollar didn't disintegrate in months instead of over 40 years.

    This PONZI scheme made it look like your house went "up": in value, actually, year after year, it just took more degraded currency to replace the dollars of the previous year--you thought it was a prince increase, it was actually, a dollar's buying value decreasing.--magnified by a small downpayment. Your $1.00 house is worth $1.20 in three years, but your downpayment doubled from 20 cents, to 40 cents. Aren't you a genius to make such a good "investment".

    While authors win awards for saying "diversify" the only reason all assets in the real world work their way "upward" in value, making that happen, is that a degraded currency inflates all assets equally. The same genius that created no doc loans, they're predecessors won doctoral degrees declaring diversification an answer BECAUSE everything "inflated" in price compared to the value of the dollar or other paper currency.

    So, arguing the Dow or the S and P or the Russell 3000 is less or more important is a joke if the whole system relies on the degradation of the dollar to show that 6% a year falling to the bottom line. That's right, if a firm isn't making six percent, it isn't even breaking even with the degradation of your currency.

    In 1971 I made 10K a year, bought a car for $3500, and a house for $40,000.

    In 2012 I need 100K a year, to buy the same car for $35000 and a house for $400,000.

    If everything is 10X, and costs the same manhours of work to buy now then in past, there is no growth.

    The S and P growth rate adjusted for the bogus rate of inflation of 2% since 1971 is 8X, of which 4X (half) is reinvested dividends.

    The S and P growth rate adjusted for the real rate of inflation of 1.0587% is ZERO percent, of which half the value of just breaking even, was dividends.

    See how that works? Would make Madoff proud..

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