The Greatest Investing "Secret"

I've read quite a few investing-related books in my time, but Jeremy Siegel's The Future for Investors was a real eye-opener. There are powerful lessons in the book that can help your financial performance -- accelerating your returns faster than you thought possible. These principles have helped lead our Motley Fool Income Investor to market-beating performance, and I'll share them with you today.

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 point to the legitimacy that dividends lend to a company's earnings. Because the real cash paid out in dividends cannot be faked, we therefore don't have to place total trust in management's earnings reports.

But 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 rough patch 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 a positive return of more than 6% per year during that 25-year period. That's about twice the accumulation of bonds and four times better than short-term treasuries. Think about that the next time you hear someone say it took 25 years for stock investors to break even during that time!

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 dividend reinvestors 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:

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 recommend without hesitation a 30-day free trial to Motley Fool Income Investor, where Mathew Emmert's recommendations are outperforming the market. The companies he presents monthly could be just the boost your portfolio needs. Click here for more information.

This article was originally published on Sept. 30, 2005. It has been updated.

Rex Moore is a research analyst for the Fool and reinvests dividends. At press time, he owned no companies mentioned in this article. H.J. Heinz is a Motley Fool Income Investor recommendation. Pfizer is a Motley Fool Inside Value recommendation. For more on our disclosure policy,click here.