The Power of Reinvested S&P500 Dividends

Jake - Wealthy Corner Author/Founder

Jake - Wealthy Corner Author/Founder

Hi, I'm Jake. I believe you can build a wealthy life through frugal living and investing.

Intro

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:

  1. Annual S&P500 return without dividends reinvested: 6.57%
  2. 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. What does the dividend of the index represent? 

It represents the weighted average of 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). 

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 index dividend comes 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 that directly holds 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

I crunched some of Robert Shiller’s S&P500 data to build this chart. It highlights the effect of reinvesting dividends. 

I like this chart. It tells the story.  

Let’s assume you invested $1,000 into the S&P500 in 1971 (50 yrs ago). At the end of 2021 you would have:

1. $39,000 without dividends reinvested (compounded price return); or

2.  $131,100 with dividends reinvested (compounded total return).

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, fuelling a positive feedback loop (exponential growth).

Over this time, the average dividend yield was 3% and the price return was 8%. The total return was 11%. A total of 27% of the annual return was associated with dividends. 

With the current low S&P500 yield of 1.4%, dividends don’t make as large 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. 

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, like when you google “S&P500 Index”. This shows the price return chart which does not include reinvested dividends. In addition, 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 1.64%. You can find the real-time trailing 12-month yield here.

Dividends Don't Matter

Anyone who understands where stock returns come from, knows that dividends don’t matter. Only the total return matters: price growth + dividends. A company will see more share price growth if it retains earnings or uses share buybacks instead of paying cash dividends. Dividends, therefore, come at the cost of price growth. Dividends are irrelevant to the long-run total return. Although dividends are irrelevant to total return, there is a psychological effect of having cash dividend payments hit your bank account. This can keep people grounded in times of turmoil, and it can also oddly drive spending patterns (I funded my vacation with dividends).  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.

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. 

S&P500 Dividend Stability (1)

The plot and the average dividend growth rate of 6.0% tell you two important things:

    1. Dividend growth has outpaced inflation in the long term; and
    2. 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. 

Graph of S&P500 Dviidends Reinvested with Tax Drag

What about the DRIP?

Are dividends still taxed if I use the Dividend Reinvestment Program (DRIP)?

Yes. 

Dividends are automatically reinvested under 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:

  1. The dividend tax rate; and
  2. 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%. 

Bottom Line

  • 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.

Robert Shiller

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. 

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2 thoughts on “The Power of Reinvested S&P500 Dividends”

  1. Great post, Jake! Very informative. It really is a shock to see how much of a difference reinvesting the dividends makes over time. I always reinvest all dividends in my portfolio. Thanks for sharing.

    1. Thanks, Graham. The effect of dividends compounded over time surprised me as well. The wonderful nature of compound growth.

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