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ALL ABOUT DIVIDEND INVESTING
The Easy Way to Get Started
By DON SCHREIBER JR., GARY E. STROIK
The McGraw-Hill Companies, Inc.Copyright © 2011The McGraw-Hill Companies, Inc.
All rights reserved.
The Compelling Evidence for Dividend Investing
For every action there is an equal and opposite reaction.
—Sir Isaac Newton
Newton's third law of motion has a practical ability to help us understand not just physics but the effects and consequences that market cycles have on investor behavior. The idea that you will "buy and hold" through any market decline, secure in the knowledge that markets always recover as your portfolio value vanishes before your eyes, is pure nonsense! This is evidenced by the rampant but faulty "buy high, sell low" investor behavior that Wall Street thrives on.
But what if investors held stocks that provided return from two sources: price appreciation and dividends? Stock prices fluctuate; they always have and they always will. While you may not be able to count on the return from stock price appreciation, you can bank on the return you will get from dividend payments. Dividends arrive every quarter, pretty much without fail. In addition, you do not have to sell the stock to get the dividend. Once received, the tangible dividend can be reinvested, used to diversify your investment position and risk, or used to support your lifestyle.
To clearly understand the dramatic benefits that dividends might have for us in the future, let's look at what an investor might have garnered in the past.
A CLASSIC DIVIDEND STORY
Example: The owner of a grocery store in New York City who saved most of what he made during his life, Joe was one of the fortunate people who came through the Depression with some cash. In 1944, he gave $10,000 to each of his 25-year-old twin sons, Robert and Michael. Though $10,000 was a princely sum in those days—almost enough to buy a modest home—his only proviso regarding the gift was that Robert and Michael not spend the money but instead invest it against a rainy day.
It had been only a few years since the collapse of the stock market, and many investors had lost everything. And if that wasn't bad enough, we were fighting World War II.
Like everyone else, Robert and Michael didn't know where to invest the money. Their father suggested they buy big-name companies in the Dow Jones Industrial Average (DJIA) Index, those stocks that had survived the economic collapse. He also told his sons to let the dividends work for them by reinvesting them. In 1944, the DJIA offered a pretty generous dividend yield of 4.47 percent. (To calculate the dividend yield of the DJIA Index, add up all the dividends paid by the 30 stocks in the index and then divide by the total combined prices of all the stocks in the index.)
Although Michael didn't spend the gift, he could not resist spending the dividend income his stocks provided in the first year. He had good intentions to reinvest his dividends in the future but always seemed to find a reason to spend them. Like a lot of people, Michael found that spending his dividends was easier than saving them. As the years went by, Michael enjoyed his lifestyle and the extra cash his dividends provided. His initial $10,000 investment continued to grow, and by the end of 2009 it had reached $767,000, more than 76 times his initial investment. His dividends also continued to increase, providing him with more income to spend each year. The $483 in dividends that Michael received in his first year grew to more than $21,000 by 2009, providing him with 45 times more purchasing power. Amazingly, his stocks provided him with more than $370,000 in dividend income from 1944 through 2009!
Robert also took his dad's suggestion and bought the companies that made up the DJIA, but unlike his brother Michael, he chose to follow his dad's advice about reinvesting his dividends. He allowed his dividends to reinvest until he retired in 1984, when he needed his dividend income to help support his lifestyle. By 2009, Robert's initial investment increased in value, just as Michael's had, to $767, 000, but the additional shares he bought by reinvesting his dividends grew in value to more than $4.7 million. That's right, almost $5 million! By letting his dividends work for him, Robert's initial gift increased in value from $10,000 to a total of $6.5 million, more than 650 times his initial investment. His annual dividend income also soared from $492 to more than $132,000! Since 1984, he has collected more than $1.7 million in dividends from his stocks. Now that's inflation protection. (See Exhibits 1.1 and 1.2.)
Over 65 years, his dad's initial gift and the classic advantages of dividends made Robert rich. By reinvesting his dividends, Robert unleashed two powerful investment forces—compounding and dollar cost averaging—to build his wealth. Compounding builds your shares as dividends are reinvested to buy more shares each quarter. As the number of shares increases, so does the dividend, driving your share balance higher. Dollar cost averaging is the practice of systematically investing money (reinvested dividends), usually monthly or quarterly, over a long period of time. Systematic investing leads to lowering the average purchase price of shares as stock prices fluctuate. When share prices are lower, you purchase more shares.
If you find these results almost unbelievable, join the club. Many people are unaware of the tremendous benefits that dividend investing provides. And as good as this story is, it's about to get even better. These results ignore the effect of taxes, but the 65 years covered by this story sported some of the highest income tax rates in history.
If we assume that Robert paid an average tax rate of 35 percent on his dividends, he would have paid almost $395,000 in taxes on his dividends. Robert had to pay tax on his dividends even though he reinvested them. Michael had to pay tax on his dividends as he received them. As their dividends increased, so did their taxes. Although both came to love their dividend-paying stocks, they would always grumble at holiday parties about having to work just to pay the tax man. With the lower tax rates on dividends under the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA), the highest tax rate is just 15 percent. This lower tax rate would have saved Robert more than $225,000 in taxes in our 65-year example. Robert and Michael are ecstatic about the reduction in tax on dividends that this tax law provides!
Robert has begun to share his holdings with the children, but his gifts do come with one string attached. You guessed it: his kids have to continue to let the dividends work for them.
Turning $10,000 in dividend-paying stocks into millions is not a get-rich-quick story, but it is a history lesson. The benefits of dividend investing have been all but forgotten by many of today's growth-hungry investors. It's ironic that they equate dividend-paying stocks with the rocking chair set and miss out on a safe and reliable way to build wealth. (See Exhibit 1.3.)
THE DIVIDEND ADVANTAGE
Following are five reasons that explain why dividend investing works so well for investors.
Reason 1: Dividends Provide a Steady Stream of Income
This income stream delivers a return you can count on regardless of the price movements of the stocks you own or the moves in the markets in general. You can spend your stream of dividend payments as another source of ordinary income. Michael's initial investment paid just $483 in dividends in 1944, but by 2009, his yearly dividends had increased to more than $21,000, a 4,362 percent increase. Over 65 years, he collected $373,000 in dividends on his initial investment of $10,000.
Excerpted from ALL ABOUT DIVIDEND INVESTING by DON SCHREIBER JR.. Copyright © 2011 by The McGraw-Hill Companies, Inc.. Excerpted by permission of The McGraw-Hill Companies, Inc..
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