- Dividends significantly boost total returns, contributing 84% of the S&P 500’s total return over the past 60 years.
- Broad market indices like the S&P 500 and Nasdaq 100 are overvalued, suggesting the potential for sub-par future returns.
- Dividend stocks, on the other hand, tend to outperform during economic uncertainties and have a strong track record, making them a valuable addition to any portfolio.
- Year-to-date, dividend-focused ETFs like SCHD have outperformed the Nasdaq 100, and this trend is likely to continue.
It won’t come as a surprise to most of you that on the growth-value investment spectrum, my investment strategy leans heavily towards value and puts a large emphasis on dividends.
This seemingly contradicts conventional wisdom because I’m young, wellinto my wealth accumulation phase, and don’t rely on my portfolio for any income. Therefore, most financial advisers would advise me to pursue an aggressive growth-oriented allocation such as the Nasdaq 100 (NDX
But there are three good reasons why even younger investors should consider including (at least some) dividend stocks in their portfolio.
Dividends matter
First, dividends make a much bigger difference in total return than you think.
I’ve seen countless comments under articles on individual dividend stocks, REITs, and dividend ETFs, that show that many investors don’t realize just how big a role dividends play in total return, especially when reinvested.
In recent history, most broad market indices, such as the S&P 500, averaged a sub-2% dividend yield while the market climbed higher at roughly 12% per year. As a result, dividends have had a relatively low contribution to the total return – 17% in the 2010s and 15% in the 2020s, well below the 43% average contribution seen between 1960 and 2000.
Most investors in the market today did not experience the market before the 1980s and 1990s, and therefore suffer recency bias, which causes many to de-emphasize the dividend yield in investment decisions while focusing entirely on price appreciation. That is a mistake.
The S&P 500 pays a relatively low dividend yield, certainly compared to traditional dividend stocks, but still dividends have been responsible for the overwhelming majority of total returns overtime.
The magic is in dividend reinvestments.
Over the past 60 years, the cumulative effect of reinvesting dividends in the S&P 500 has boosted the total return by a factor of 6.4x ($5.1 Million vs $800 Thousand in the chart below).
In other words, the dividends (when re-invested) were responsible for 84% (=1-1/6.4x) of the total return of the index. Let that sink in.
Broad market indices are over-valued
Second, broad market indices, such as the S&P 500 or Nasdaq 100, which are heavily weighted towards growth stocks have rich valuations and are therefore (potentially) positioned to deliver sub-par returns relative to historical averages.
The S&P 500 is priced at 21.3x forward earnings, 28% above the 30-year mean of 16.7x, while the Nasdaq 100 trades at 25.1x forward earnings, 38% above the 30-year mean of 18.2x.
We can also look at the valuation in another way. In the chart below, the “exponential trend line” reflects the roughly 10% annual returns that we have gotten used to. The line is exponential (rather than linear) to capture the effect of disproportionate productivity gains that come from new technology, now at a record high weight in the S&P 500 of 31% (pg.15).
Notice that the market is now as far from the trend line in terms of percentage difference (and also standard deviations) as it was in 1970 and 2000, suggesting a level of over-valuation.
Over time, markets have a tendency to revert to the mean. In laymen terms, what goes up, must come down. And although there are many good arguments for why the market is where it is – the rise of AI likely being the biggest reason – probability is not on our side here, and it is likely that forward returns will be sub-par. In particular, J.P. Morgan’s (JPM
With such low expected returns, it makes little sense to over-weight these indices. The risk-reward looks especially poor when we consider the uncertainty related to the following risks:
- Potentially re-accelerating inflation – low risk. History warns against a second wave of inflation. But for now, inflation remains stable around 3% and is likely to decline as we work through the lag in shelter and auto insurance inflation. Still, until CPI declined below the Fed’s 2% target we should not dismiss this risk, especially in light of President Trump’s unpredictable and potentially inflationary tariff policies.
- Recession – medium risk. The Atlanta Fed’s Real GDP has made headlines as it moved into deeply negative territory. The sharp drop in expected growth was caused by a significantly negative trade balance, which isn’t likely to persist, skewing the forecast downwards. On the other hand, the labor market remains solid with unemployment at 4.1% and a number of economic surveys are signalling an economic recovery, which is the opposite of what we would expect before a recession. Still, big banks are predicting a probability of a recession over the next year of roughly 40-45%. And the bond market is pricing in a 27% chance of recession. These probabilities should be taken with a grain of salt, of course, because every single year there is roughly a 15% chance of a recession (as a recession happens every 6.5 years on average). Moreover, the bond market was pricing in a much higher likelihood of a recession in 2022 and the recession never came. On the contrary, prior to 2001 and 2008, the probability of a recession only stood at 40%. The bottom line here is that recessions are difficult to predict, and we shouldn’t pretend that one is coming. At the same time, however, given the economic and political uncertainty, I think it’s fair to conclude that the chances of a recession are currently somewhat elevated.
That is not great news for the broader stock market which tends to do rather poorly in a recession, while more defensive sectors – such as dividend aristocrats, and as you’ll see below dividend payers generally – tend to outperform.
Dividend stocks have a stellar track record
And finally, the third reason why younger investors should consider dividend stocks is that they have a very good track-record. Especially those that have a history of growing their dividends at an above-average pace. As shown in the chart below, over the past 50 years or so, those stocks that have demonstrated lasting dividend growth have outperformed the equal weighted S&P 500 by a factor of 3.5x.
And there’s more. Not only is a portfolio of “dividend growers” able to outperform the broader market indices, but it is able to do so with lower risk. This is evident from a much lower average decline of dividend growers in bear markets, compared to the equal-weighted universe of stocks (i.e. the S&P 500).
I believe that dividend growth stocks are the answer in this environment. And it appears that the market agrees, as year-to-date, dividend growth stocks have outperformed the Nasdaq 100 by almost 8%. And crucially, I believe that this outperformance could persist for the remainder of the year, and beyond.
And I consider Schwab U.S. Dividend Equity ETF (NYSEARCA:SCHD
Its holdings are well diversified between sectors with an emphasis on dividends, but also quality – SCHD is NOT full of high yield value traps.
Note that the index rebalances annually based on criteria well explained in an article by The Sunday Investor. After the most recent rebalancing just days ago, Energy has become the highest weighted sector at 21%, followed by Staples and 18% and Health Care at 12.7%. Financials saw the biggest weight decline, going from 17% to only 8%. And crucially, technology remains at a sub-10% weight. This is important because technology is arguably the most over-valued component of the broad market indices and could be the reason why the S&P 500 under-performs as valuations revert to the mean.
Moreover, SCHD pays a solid nearly 3.6% dividend yield and, crucially, has a history of increasing its dividends with a 5-year and 10-year CAGR of 5.5% and 8.3%, respectively.
In my mind, this makes SCHD a great candidate to include in your portfolio and therefore a BUY at current levels.
Photo by Tomas Eidsvold on Unsplash