All DIY Investors Should Understand Dividend History
A study of S&P500 history is useful for boring index investors like me. After all, S&P 500 index funds are extremely popular among investors. Combined, the mammoth index funds VOO and SPY have over $1 trillion invested in the S&P500.
Looking back at S&P500 dividend history can teach you some useful things:
- How dividends affect total S&P500 returns
- Dividend stability
- Dividend growth rate
- How taxes affect total returns with dividend reinvestment.
Dividend Contribution to S&P500 Returns
If you crunch the numbers on S&P500 returns over the last 100 years (1921 – 2021), you will find the following:
- Annual S&P500 return without dividends reinvested: 6.57%
- Annual S&P500 returns with dividends reinvested: 10.7%
What Are S&P500 Dividends?
The S&P500 index is a collection of 500 large profitable U.S. companies. The S&P500 dividend represents the total dividends paid out by these 500 companies.
A dividend is a cash payment to shareholders. It is a way for a company to share its earnings with company owners (you). Share buybacks are another method that can be used to give back to shareholders.
Not all companies in the S&P500 pay a dividend. Google is a good example.
Huge companies like Apple make up a larger part of the index than small companies. This type of index is called a Capitalization Weighted Index.
This means that most of the S&P500 index dividends come from the largest companies in the index.
Learn more about the mechanics of indices and index funds in this post.
How to Access S&P500 Dividends
You can access the dividends of the S&P500 index by investing in an index fund. An S&P500 index fund will directly hold all 500 stocks in the S&P500 index.
These 500 stocks will pay dividends. The fund will collect the dividends and distribute them to you, usually every 3 months.
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S&P500: No Dividends Reinvested vs. Dividends Reinvested
Let’s assume you invested $1,000 into the S&P500 in 1971 (50 yrs ago). Today you would have:
1. $39,000 without dividends reinvested (total return); or
2. $131,100 with dividends reinvested.
Over 70% of the total return is attributed to reinvested dividends.
You can thank compound growth for this effect. Dividends are used to buy more index ETF shares. These shares in turn yield more dividends. The cycle repeats and repeats, fuelling a positive feedback loop (exponential growth).
With the current low S&P500 yield of 1.4%, dividends don’t make as big of a contribution as they did in the past. But even a 1% difference in returns will result in a huge difference when compounded over the long term.
The Low Interest Rate Environment
Low interest rates push up valuations due to a lower discount rate. These increasing valuations reduce the dividend yield.
To understand more about the relationship between interest rates and valuations, you can read about Discounted Cash Flow Analysis.
In addition, the S&P 500 is heavily weighted with mega-cap growth tech stocks. These monsters favor share buybacks to return money to shareholders rather than dividends.
Discounted cash flow analysis is not needed unless you buy individual stocks. Even if you do, you will likely fail to beat the returns of index funds over the long term.
Price Return vs. Total Return Index
The index value with re-invested dividends is called the “Total Return Index”. Otherwise, it’s called a “Price Index”. The price index is proportional to the weighted market caps of the underlying companies in the S&P500 index.
You normally see the price index. When you google “S&P500 Index”, it will return the price chart which does not include reinvested dividends. And the value of an index ETF security follows the price index. It took me a while before I figured this one out.
As of writing this, the S&P500 dividend yield is nearing its all-time low of 1.4%. You can find the real-time trailing 12-month yield here.
S&P500 Dividend Growth and Stability
S&P500 dividends have grown at an average annual rate of 6.0% per year between 1971 and the present (based on Shiller’s Data).
I’ve graphed out the S&P500 dividends relative to S&P500 earnings, adjusted for inflation. Dividends are sturdy.
The plot and the average dividend growth rate of 6.0% tell you two important things:
- Dividend growth has outpaced inflation in the long term; and
- Dividend growth is stable relative to S&P 500 earnings, and even more stable relative to the S&P500 index price.
If you like stability and have lower risk tolerance you’ll naturally gravitate towards dividend-yielding business or indices. I personally find comfort in a robust growing dividend from an index or an individual stock.
Taxes: A Drag on Dividend Compounding
Dividends are taxed, even if you reinvest them immediately. This imposes a “tax drag” that reduces the compounded effect.
The good news is that you can avoid tax drag completely by using tax-sheltered accounts (RRSP, TFSA, 401K, Roth IRA, HSA, ect). Just watch out for Foreign withholding tax drag if you invest in foreign equities – I talk more about this here for Canadians.
In addition, dividends will be taxed at lower tax rates compared to employment income. To learn more about taxes, check out this guide on investment taxes for Canadians.
This plot shows the result of a 15% tax drag on total S&P500 returns.
What about the DRIP?
Are dividends still taxed if I use the Dividend Reinvestment Program (DRIP)?
As a refresher, dividends are automatically reinvested under the DRIP to buy more shares of the stock or ETF, without paying commission fees.
This doesn’t work for any stock/ETF, you first have to make sure the security is DRIP eligible.
How to Calculate Tax Drag
The overall tax drag represents the loss in total returns from dividend taxes. The drag depends on two factors:
- The dividend tax rate; and
- The dividend yield.
Consider an investor named Kara. Kara pays a 15% tax on dividends. She holds Vanguard’s VOO S&P500 ETF that provides a 1.4% dividend yield.
Kara will have an overall dividend tax drag of: (15%)(1.4%) = 0.21%. So, her total returns will be 0.21% lower than the Total S&P500 index returns.
But, there are also fund fees that add additional drag. The total tax drag including fund fees can be found by adding the MER to the dividend tax drag.
VOO has a tiny MER of 0.03%. The total tax drag will then be: (15%)(1.4%) + 0.03% = 0.24%. Kara’s returns of holding VOO will be 0.24% lower than the total S&P500 return.
This 0.24% compounded over 30 years at a 10% return results in a portfolio value at the end of year 30 that is 6.34% lower relative to the no-fee case.
This is insignificant, especially relative to mutual fund fees of 1% to 2.5%.
- The price of the ETF or individual stock that you see on searches normally does not include reinvested dividends. Look up the total return if you want to the return with reinvested dividends.
- Dividends are a large component of total S&P 500 index returns, with 40% of the annualized return attributed to dividends over the past 100 years.
- Dividends are much more stable than earnings or index prices over time.
- S&P500 dividends have grown at 6% annually over the past 50 years, beating inflation.
- Tax drag on the compound effect will reduce total returns, even if you use the DRIP.
You’ve heard me reference Robert Shiller a few times as I used his data. I allocated 10 hours of my life to his book “Irrational Exuberance” so I’ll tell you a bit about him.
He is a well-known economist who argues that human behavior has a large effect on markets during booms and busts. Sometimes, we can act irrationally in aggregate, becoming a tad exuberant at times.
Robert Shiller also developed the famous market valuation metric – the Shiller P/E ratio, also known as the Cyclically Adjusted Price to Earnings Ratio (CAPE Ratio). It shows how expensive the stock market is relative to history.
The metric shows that the S&P500 in 2021 has an extremely high valuation relative to history. Given high valuations, regression to the mean implies lower expected future returns.
Thanks for reading. I hope this helps you along your wealth-building journey.