But that’s okay – because while dividends are not necessarily sexy, they are a foolproof way to reel in consistent, predictable returns in the market. And for decades, seasoned investors have leaned on dividends to help power their portfolios through both good and bad times in the market.
What is a Dividend?
When a company earns a profit, it essentially has two options.
- Re-invest in the business This is the option chosen by many high-growth companies. They pay down debt, or expand their operations to make more profit in the future.
- Issue a dividend to shareholders A dividend is a share of after-tax profit of a company, distributed to its shareholders according to the number and class of shares held by them. How and when is a dividend issued?
Both the amount and timing of dividends is determined by the Board of Directors Usually for public companies, dividends happen on a quarterly or annual basis Most dividends are declared by large and established “blue chip” companies (i.e. P&G, McDonald’s) Dividends are often paid if a company is unable to reinvest its cash at a higher rate than shareholders
Most importantly for investors, dividends from good companies should be predictable and sustainable. Some companies like Coca-Cola have been paying out uninterrupted dividends on common stock for over a century.
The History of Dividends
1250 The first company to ever pay a dividend was likely a French bank called Société des Moulins du Bazacle, which was formed in 1250. 1602 The Dutch East India Company was the first company to offer shares of stock. It famously paid a dividend that averaged around 18% of capital over the course of the company’s 200-year existence. 1684 The Hudson Bay Company was likely the first North American company to have paid a dividend. The first dividend went to shareholders 14 years after the company’s formation in 1670, and was worth 50% of the par value of the stock. 1910 In the early 20th century, most investors only cared about dividends. At the time, stocks were expected to have a higher dividend yield than bonds to compensate investors for the extra risk carried by equities. 2003 Microsoft declares its first dividend after 28 years of rapid growth. Today, roughly 422 of the 500 stocks on the S&P 500 pay a dividend, including companies like 3M, Chevron, Walmart, and McDonald’s.
Why is Dividend Investing Powerful?
Most investors are aware of the power of compound interest – and dividends work in a similar way, especially when dividends get reinvested back into the company. That’s why investing $10,000 in Coca-Cola in 1962 would have yielded more than $2 million by 2012, which is 50 years later. Dividends get reinvested to buy more stock, which produces more dividends, and so on. The advantages of dividend investing are as follows:
Companies can increase dividends over time. (P&G, for example, has increased their dividend every year for 60 years) Companies can’t fake dividends – a company either declares a dividend, or it doesn’t Dividends protect against inflation. (Dividends have increased 4.2% since 1912, and inflation has increased 3.3%) Dividends create intrinsic value, as they generate cash flow for investors Dividends can help combat volatility – that’s because dividend yield increases as the market price of a stock falls, making the stock more attractive
Dividends are a key way for companies to give back to shareholders, and in the right situation, dividend stocks can be a powerful component in an investor’s portfolio.
on Last year, stock and bond returns tumbled after the Federal Reserve hiked interest rates at the fastest speed in 40 years. It was the first time in decades that both asset classes posted negative annual investment returns in tandem. Over four decades, this has happened 2.4% of the time across any 12-month rolling period. To look at how various stock and bond asset allocations have performed over history—and their broader correlations—the above graphic charts their best, worst, and average returns, using data from Vanguard.
How Has Asset Allocation Impacted Returns?
Based on data between 1926 and 2019, the table below looks at the spectrum of market returns of different asset allocations:
We can see that a portfolio made entirely of stocks returned 10.3% on average, the highest across all asset allocations. Of course, this came with wider return variance, hitting an annual low of -43% and a high of 54%.
A traditional 60/40 portfolio—which has lost its luster in recent years as low interest rates have led to lower bond returns—saw an average historical return of 8.8%. As interest rates have climbed in recent years, this may widen its appeal once again as bond returns may rise.
Meanwhile, a 100% bond portfolio averaged 5.3% in annual returns over the period. Bonds typically serve as a hedge against portfolio losses thanks to their typically negative historical correlation to stocks.
A Closer Look at Historical Correlations
To understand how 2022 was an outlier in terms of asset correlations we can look at the graphic below:
The last time stocks and bonds moved together in a negative direction was in 1969. At the time, inflation was accelerating and the Fed was hiking interest rates to cool rising costs. In fact, historically, when inflation surges, stocks and bonds have often moved in similar directions. Underscoring this divergence is real interest rate volatility. When real interest rates are a driving force in the market, as we have seen in the last year, it hurts both stock and bond returns. This is because higher interest rates can reduce the future cash flows of these investments. Adding another layer is the level of risk appetite among investors. When the economic outlook is uncertain and interest rate volatility is high, investors are more likely to take risk off their portfolios and demand higher returns for taking on higher risk. This can push down equity and bond prices. On the other hand, if the economic outlook is positive, investors may be willing to take on more risk, in turn potentially boosting equity prices.
Current Investment Returns in Context
Today, financial markets are seeing sharp swings as the ripple effects of higher interest rates are sinking in. For investors, historical data provides insight on long-term asset allocation trends. Over the last century, cycles of high interest rates have come and gone. Both equity and bond investment returns have been resilient for investors who stay the course.
