It's Your Money: The Amazing Power of Dividends

Investing, at its most basic description, is about growing wealth -- it's that simple. And there are as many methods to invest as there are people. However, the one method that has been shown to be most effective for the most people is, arguably, the most boring: Invest in great companies at good values and hold your investments for as long as you can. And this is where things get more complicated.

What's a great company? How long is a long time? How do you measure good value?

One method is to look for predictability and income through dividends -- something that's usually found in the 30 companies that make up the Dow Jones Industrial Average. Let's take a look at the performance -- with regard to both stock-price appreciation and dividends -- of some of the Dow components since 1990 and see what this method can do for your portfolio. 

Strong returns owe largely to dividends
The Dow changes from time to time. Companies are merged and acquired; some lose relevance, while others grow more central to the economy and modern life. As of this writing, there are 13 companies in the Dow today that were in the index in January 1990. While the Dow itself is up 445% since then, the 13 longtime members of the Dow are up 645%.

Now here's the kicker: Add in dividends, and the return nearly doubles to 1,129%. That's more than three times better than the market over the past 23 years, good for an average annualized return of more than 11%. If you had invested $1,000 in each of the 13 companies still in the Dow back in January 1990, your $13,000 investment would be worth more than $146,750 today, and 46% of your return -- that's $67,000 -- would be from dividends. That's how powerful the combination of time and money, Warren Buffett's "magic of compounding returns," really is. 

In 1990, Coca-Cola (NYSE: KO  ) was pretty well-known around the world, and it was one of the great investing stories of the past 50 years. With annual sales of more than $10 billion, how much larger could it grow? Today, annual sales are north of $50 billion, and shareholders have seen a total return of 1,170%. As for dividends? More than one-third of Coca-Cola's return since 1990 has been in the form of dividends paid. But anchoring on the company's past success may have led many investors to take a pass.

General Electric  (NYSE: GE  ) , a member of the Dow since 1907, is another great example of how past success doesn't mean a future lack of it. On the surface, the 337% return for GE's stock price since 1990 looks paltry, trailing both the S&P and the Dow over the same time frame. But when we factor dividends into the equation, the return balloons to 739% -- not a bad haul at more than 9% annualized.

However, GE offers us another valuable lesson as well: Dividends aren't guaranteed. In early 2009, GE slashed its dividend by two-thirds as losses in its finance arm, GE Capital, weighed heavily on the company's performance. This is where diversification comes in.

Easy ways to invest in dividend payers
Back in 1990, there really wasn't any way to invest in just the Dow outside of buying shares of all the companies. However, ETFs have changed that. The SPDR Dow Jones Industrial Average ETF  (NYSEMKT: DIA  ) gives investors an easy way to own the Dow and make it a balanced part of their portfolio while still collecting the dividends that Dow companies pay, currently yielding about 2.4%.

There's also the Ishares Trust Select Dividend ETF  (NYSEMKT: DVY  ) , which pays about 3.2% in dividends and is comprised of close to 100 companies with strong records of consistent dividend payouts. It pays a 50% higher yield, but it's not tied to a specific index. This means that to some extent, you are relying on the fund's managers to make the best investment decisions.

The risk here? Most actively managed funds underperform their benchmarks. This particular fund has underperformed the Dow and the S&P since its inception in 2003, both on a share-price basis, and a total-return basis. What does that say for future returns? Simply that there's no guarantee that any actively managed fund will outperform an index.

The long and short of it
Every investor should consider investing a portion of their portfolio in dividend stocks. While we all want the "big winners," a few bad picks can wreck long-term success, and diversifying with a basket of more predictable, stable companies will solidify your performance. 
Don't get me wrong: It's not just about protecting the downside; it's about growing your portfolio. After all, that's why we invest. And over time, the compounding power of reinvested dividends will go a long way toward building wealth.

The best investing approach is to choose great companies and stick with them for the long term. The Motley Fool's free report "3 Stocks That Will Help You Retire Rich" names stocks that could help you build long-term wealth and retire well, along with some winning wealth-building strategies that every investor should be aware of. Click here now to keep reading.


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