I am working on my What is a mutual fund? category at About.com and a thought struck me. I wanted to go back and look at the most recent investing lifetime (the 50 year period between 1960 and 2010). I imagined that an investor could have bought the S&P 500 stock market index (obviously you can’t since an index is just a theoretical construct but you could have built a portfolio to mirror it provided you had enough capital; at least until the rise of the now indispensable index fund). I took the index value and made it a dollar value – that is, the S&P 500 at 58.11 in 1960 would be the same as a share of stock in America, Inc. at $58.11.
[mainbodyad]But it’s not enough to look at historical data in nominal dollars. As investors, we are interested in purchasing power. Warren Buffett called this the cheeseburger test. How many cheeseburgers can you buy today compared to yesterday? It’s purchasing power we’re after; dollars are merely an exchange mechanism to approximate value. But governments print money, so it takes more dollars over time to buy the same goods and services.
Using the historical change in the consumer price index as a proxy for the inflation rate, I went back and adjusted the S&P 500 level, the S&P 500 earnings, and the S&P 500 dividend rates into 2010 dollars. For now, since this is a very 30,000-foot-altitude view of the market, I ignored transaction costs and taxes. Again, with a large enough portfolio, transaction costs would have been almost non-existent due to low turnover and some sort of tax shelter could have been used, which is especially true going forward in time now that we have seen the rise of the Roth IRA and Roth 401(k) plans. I also didn’t get into specifics with the handling of spin-offs and other special events, just using return information provided by Bloomberg and S&P. These are more akin to notes you’d find scribbled on the inside of a folder in my library than I would publish with my name on them in an academic paper so keep those limitations in mind. I’m only sharing because I thought a few of you might find this interesting for broad policy reasons.
Chart: A Look at Inflation-Adjusted S&P 500 Data for 1960 Through 2010
A chart detailing the most recent "investment lifetime", the 50 year period between 1960 and 2010. It includes 51 years of compounding assuming you began investing on January 1st of 1950 and sold out of your investments on December 31st of 2010. Figures are adjusted to 2010 dollars to provide a better gauge of actual utility. For example, a $1.98 dividend in 1960 is worth a $14.41 dividend in 2010 in terms of purchasing power.
Imagine the year is 1960 and you are 18 years old. On a whim, you purchase a single share of America, Inc. for the equivalent of $422.93 in 2010 dollars. You allow your money to remain invested for 51 full trading years. How did you do? It depends on whether you chose to reinvest your dividends or enjoy them along the way. We’ll look at each scenario.
Scenario 1: Your Returns on the S&P 500 Without Dividends Reinvested
What happened by the end of that period if you decided not to reinvest your dividends? Your $422.93 would have grown to $2,229.66 in real, inflation-adjusted dollars.
[mainbodyad]This return would have come from several sources. First, you would have received the equivalent of $972.02 in the mail from dividend checks that you could have spent on movies, furniture, video games, clothing, bills, vacations, or whatever else you desired. On a retroactive basis, this would average out to 5.6% on your beginning investment, or $23.71 annually. The remaining gain of $1,257.64 would consist of your share of America, Inc, which would have a cost basis of $422.93 and a capital gain of $834.71.
That means your end-of-term value of $2,229.66 would consist of three components:
- $422.93 in returned cost basis for original investment
- $834.71 in capital gain on share of America, Inc.
- $972.02 in cash dividends mailed to you over the years
In inflation-adjusted terms that represents a real gain in purchasing power of 4.14% compounded annually, more than half of which you enjoyed spending along the way.
Side note: Something interesting … the S&P 500 had look-through earnings of $2,293.26 on an inflation-adjusted basis and paid out $972.02 on an inflation-adjusted basis as dividends, resulting in retention of $1,321.24 in inflation-adjusted dollars. In simple terms, if you invested $422.93 and your share subsequently earned $2,293.26, you should have $2,716.19 in wealth. Yet, your total pre-tax proceeds came to only $2,229.66. That is a short-fall of $486.53. It might indicate that corporate management did not, on average and through this investment period, produce $1.00 of market value for every $1.00 in shareholder capital retained. This is why many activists push for increased dividends instead of letting executives hoard cash; it’s almost human nature – they can’t help but do something stupid when easy money flows. But I’d be cautious about relying on that too heavily since I haven’t accounted for spin-offs and other corporate actions.
Scenario 2: Your Returns on the S&P 500 With Dividends Reinvested
If, instead, you had reinvested your dividend checks along the way, your 1 share of America, Inc. would have grown to 4.84 shares by the end of 51 years. With a market value of $1,257.64, your total position would be worth $6,086.98. That is a real, inflation-adjusted return of 6.72% compounded annually on your money. Every $1.00 invested became $14.39 in purchasing power.
To Reinvest Dividends or Not to Reinvest Dividends. That Is the Question
Which would you rather have?
- A $422.93 investment that grows to $1,257.64 but pays out $972.02 in cash dividends to spend along the way; or
- A $422.93 investment that grows to $6,086.98 but pays out no dividends along the way
There is no right or wrong answer. It comes down to personal utility for you and your family. If your goal was to put aside a pile of money for capital accumulation to draw upon during retirement, as I did with the KRIP portfolio, reinvesting the dividends is most definitely a better long-term option. But if you sold a company or an asset, parked the money in diversified investments, and wanted to live off the dividends, interest, and rental income, the utility of being able to fund your lifestyle is more important because, let’s face it, none of us lives forever. The goal of investing is to increase your utility so you can have the life you want. Capital is meant to be used, not hoarded. It’s sole value comes from its ability to improve the quality of the human experience.
Reader Comments (6)
Comments are presented chronologically, with replies indented beneath the comments to which they respond.
Ah6bird
October 14, 2011
Very interesting. It seems that the entire idea of "buy and hold" has been shot down since 2000. Can you chart columns D and G by year?
Joshua Kennon
October 14, 2011
Replying to Ah6bird
Welcome to the site! Thanks for commenting!
Imagine that your doctor told you "drinking milk is good". So you went home and drank a huge glass of milk that had been left on the counter for 3 days. Your results are going to be terrible, painful, and unpleasant, even thought you drank milk.
To apply this to finance:
No rational investor would have bought large capitalization equities in 2000 because earnings yields were half the rate of the long-term United States Treasury bond. If you go back and find news stories from that period, virtually all of the well-established investors with good long-term records were writing editorials and being called dinosaurs by warning the public that the current prices were unsustainable. The reason is simple: The return you earn is always determined by the price you pay relative to profit. If you buy a lemonade stand that earns $1 per year and you pay $10, your return is 10%. If you pay $20 for that same lemonade stand, your return is 5%. If you pay $100, your return is 1%.
The same business. The same profit. Your return was determined by the price you paid for that profit.
A fairly priced stock is one in which the multiple applied to after-tax profit (the price to earnings ratio) is equal to the growth rate in earnings per share; in other words, a PEG ratio of 1.0 with the rule being that exceeding a ratio of 2.0 means you are going to earn returns below the long-term average for equities, which has been around 6% to 7% in real, inflation-adjusted terms before taxes.
An example may help. Take a huge blue chip stock from the Dow and S&P during the 2000 to 2010 period. For someone "buying and holding" Johnson & Johnson at 50x earnings, which is where stocks were in 2000, they would have needed to believe the underlying profit per share was going to grow by 50% per year, a virtual impossibility given that JNJ was already one of the biggest companies in the world. If they wanted average returns, they would have needed to believe the stock was going to grow by 25%, also a virtual impossibility given the firm's size.
If you buy at an irrational price, your returns are going to mirror that. Over long periods of time (20+ years), returns for a fairly priced stock are nearly always going to match the return on equity earned by the underlying business.
In other words, buy and hold never stopped working if you are intelligent about when you buy. You cannot overpay for ownership in a business and expect to do well, just as you cannot overpay for a house, a work of art, a musical instrument, a race horse, a diamond necklace, or a rare book and expect to do well. Anyone purchasing in the year 2000 was a fool that, as the saying goes, was soon parted with his money. Choosing it as an arbitrary starting date without accounting for valuation arrives at a false conclusion: The price you pay for your stake matters.
As I've written about in the past by way of example, I for one want nothing more than to buy a very large block of ownership in a company called Brown-Forman. I would like to then leave the shares parked on my balance sheet for decades. But it is overpriced, in my opinion. So I restrain myself and refuse to buy. One of these days, I'll likely get my price, and become an owner.
Also, buy and hold never worked for cyclical stocks. It would be a disaster for cyclical stocks. But I've written a lot about that in the past.
J. Dias
April 17, 2022
Replying to Joshua Kennon
Very true and applicable today in April 2022. I fear putting large sums of my money in the market right how, however, I also fear inflation's impact on cash. What to do?
Joshua Kennon
October 14, 2011
Replying to Ah6bird
I should also point out the "dividend yield" is deceptive due to changes in American tax law and business culture. Some companies, such as AutoZone, return virtually all profits to owners. But instead of sending a check out the door, management values the business and repurchases shares, destroying them, as a way of returning money to stockholders. That way, each remaining share represents a bigger ownership stake in the business.
AutoZone is the ultimate dividend company. It just doesn't pay a dividend. There needs to be some sort of modified metric that shows dividends + net reduction (if any) of outstanding share count as a percentage of market price to reflect the "real" dividend rate. Share repurchases were very rare 50+ years ago so the dividend yield appears as if it has been declining when that isn't the entire story.
Ah6bird
October 17, 2011
Replying to Joshua Kennon
Joshua,
You make some very valid points, but one need not pick 2000 as a starting point. You could even use 1997 or 1998. What if someone were in high school or college in the 90s, and wasn't able to invest then (beyond $50 here, $50 there DCA). They then enter their careers around 2000, are fortunate to have jobs (unlike today's grads), and start dollar-cost averaging with 401k and IRA? How many people do you know who are under 40 who have seen true increases in their portfolios through market appreciation with a long-term buy and hold or DCA purchasing of the S&P500 (which was the previous benchmark for mutual funds to beat), not through luck and timing on .com stock options?
It would be interesting to know how much money is parked on the sidelines in money markets simply because investors have no faith in the markets' abilities to deliver.
Mutual funds are happy to market their 5-year ROI if it's good, but if someone points out a particular timeframe that hasn't been good, somehow it's arbitrary and not reflective of long-term trends.
Alan Newman at Cross Currents had particularly good insight on the lack of long-term gains for investors since 1998.
Ah6bird
October 17, 2011
Replying to Joshua Kennon
Joshua, I find it interesting that you mentioned Autozone and Brown Forman. Both of these companies offer "real" products with recurring revenue streams that are somewhat immune to economic upturns and downturns. I recently had a conversation with other small business owners about the value of recurring, steady revenue.
If you look at the most powerful country in Europe- Germany- they make goods that consumers want to buy on a global level. If the US had maintained its ability and desire to do that- beyond the likes of Cat and Boeing......into the small/mid size manufacturers, think about where our employment figures would be today.