The S&P 500 is hands-down the most-followed index on the stock market. Tracking the 500 largest public U.S. companies by market cap, the S&P 500's performance is often used interchangeably with the stock market's performance as a whole. There are many great lessons to be learned from the S&P 500, but few are as important as the power of reinvested dividends.

The S&P 500 often reigns supreme

Since its inception in 1957, the S&P 500 has consistently provided long-term returns that few stocks have come close to duplicating. In fact, the S&P 500 has become the standard to the point that when professional investors on Wall Street put together funds, they often do so hoping to outperform the S&P 500. Despite all the data and technical resources at their disposal, most fail to do so over the long run.

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Warren Buffett famously bet a hedge fund manager $1 million that the S&P 500 would outperform a group of hedge funds over a decade, and by the ninth year, the S&P 500 had posted cumulative returns (total returns over a set span) of 85.4% while the hedge fund average cumulative return was 22%. Three of the five funds tracked against the S&P 500 had cumulative returns of only 2.9%, 7.5%, and 8.7% at that point.

You can thank dividends

The large role of dividends in investors' total returns is often underappreciated. This is especially true when you use a dividend reinvestment program (DRIP). A DRIP takes the dividends you're paid and automatically reinvests them back into the stock that paid them. For example, if you get paid a $25 quarterly dividend from a fund, the payout would be used to buy $25 worth of stock. Even with seemingly small dividend payouts, they can make a world of difference over time because they add to the compounding effect.

Nowhere is the power of reinvesting dividends more prevalent than with the S&P 500. Without taking dividends into consideration and just stock price, a $10,000 investment in the S&P 500 in 1960 would've been worth over $795,800 at the end of 2021. If you look at the S&P 500's total return from 1960 to 2021 with reinvested dividends, a $10,000 investment would be worth just under $4.95 million.

Put another way, over the past 60 years or so, reinvested dividends and compound earnings accounted for 84% of the S&P 500's total return.

Patience will reward you

One of the best things you can do is reinvest your dividends until retirement and then start taking them as cash payouts for supplement income. The "small" dividend payouts won't make too much of a difference if you receive them as cash along the way, but if you reinvest them and let compound earnings work their magic, they can pay off handsomely in retirement.

Historically, the S&P 500 has returned around 10% annually over the long run. Let's imagine it has a consistent 2.5% dividend yield, and you invest $1,000 monthly into an index fund for 20 years at those returns. Here's the difference in account totals between no dividend and reinvesting the 2.5% dividend yield:

Monthly Contribution Average Annual Return Account Total After 20 Years
$1,000 10% $687,300
$1,000 12.5% (including dividend) $916,300

Data source: author calculations

By just reinvesting dividends over that span, you can manage to accumulate around $229,000 more. With $916,000 in an index fund paying a 2.5% dividend yield, that's $22,900 in annual dividend payouts. That may not be enough to carry you through retirement, but it's without a doubt a great source of income.