Why you should believe in the power of dividends

To some investors, a steady dividend yield of 3 percent is a rounding error… and many investors think that dividend stocks are better suited for widows, orphans and retirees.

But that’s a big mistake. Dividends are one of the best ways to grow your wealth. And in investing, boring consistency is a very exciting thing.

High-quality dividend stocks rarely post spectacular returns. They usually don’t go up as much during market rallies. And they don’t go down as much when markets fall. They also tend to outperform the broader stock market over long periods.

Of course, not all dividend stocks are created equal. While some may pay high dividends today, those dividends could disappear when the economy falters. So it’s critical to focus on companies that have paid dividends steadily over the years – through economic cycles, change in management, shifts in consumer preferences, and other challenges.

Dividend stocks also open the door to the most powerful force in finance: Compound interest.

That means that even if a dividend is a paltry-sounding 3 percent, it adds up over time. If you earn $3 on a $100-dollar investment, then reinvest the $3, the following year you earn 3 percent on $103. The next year you would earn 3 percent on $106.09, and so forth as shown below.

When these compounding dividends are re-invested in a growing company, with a growing stock price, the returns earned are that much more.

This is why investors who opt to re-invest their dividends, rather than pocket the income, will have far better investment returns.

For example, investing in the S&P 500 from 1970 until the end of 2015 without dividend investment would have generated a return of 2,098 percent, or roughly 7 percent per year.

That’s nowhere near as good as the 8,762 percent return generated with dividend reinvestment (for slightly more than a 10 percent annual return). That’s the power of compounding an extra three percentage points of return (which is the average dividend yield for the S&P 500 over that period).

For the MSCI Asia ex Japan index, it’s a similar story. Since 1988, the index has returned 400 percent. But if you had reinvested the dividends, your return would have nearly doubled, to 758 percent. Since 1995 (the furthest back the dividend yield is reported), the average yield for this index has been 2.5 percent.

The difference is astounding – and is one reason why investors should consider high-quality dividend stocks for their portfolio.

This impact is all the greater for stocks that consistently raise their dividends, year after year. These companies are often called “dividend aristocrats.” They don’t necessarily pay the highest dividends, but they regularly increase the dividends they pay.

These increases can also add up over time. Imagine you buy a stock for $10 a share that pays a 2 percent dividend. The $0.20 you earn as a dividend may not sound like much, but it means that you will earn $0.20 every year just for owning the stock.

Let’s say that over the next three years, the dividend doubles – and so does the share price. That would mean the stock is now worth $20 per share and the dividend is now $0.40 per year. And the dividend yield is still 2 percent.

But remember, you bought the stock at $10. So the $0.40 dividend you’re now earning means that the dividend yield on your purchase price is 4 percent (0.40/10). If the dividend doubles again over the next five years, your yield is now 8 percent on the $10 you originally paid. If it doubles again, your yield jumps to 16 percent. (Dividend yields don’t normally double every few years, but it’s not unheard of.)

In this sort of situation, you might be inclined to sell the stock. But remember: Based on your purchase price (which is what matters), you’re earning 16 percent per year – just to hold the stock. That’s a return that’s nearly impossible to generate consistently any other way.

For Asia, dividend aristocrats include companies like China Construction Bank (Hong Kong; code: 939) and Simplo Technology (Taiwan; code: 6121).

These are included in the S&P Pan Asia Dividend Aristocrats index. This index tracks companies throughout Asia Pacific markets that have increased dividends seven years in a row. They also have to be companies of a certain size and show that they generate sufficient profits to continue paying the dividends they have promised to investors.

You can buy an ETF that tracks this index on the London Stock Exchange (ticker: ASDV). Or, you can buy the BMO Asia High Dividend ETF on the Hong Kong Exchange (code: 3145). It tracks the NASDAQ Asia ex Japan Dividend Achievers index. This includes companies that have raised their dividends for at least three years in a row.

Performance figures for this index only go back just over one year, so it’s too early to judge its performance compared to the broader MSCI Asia ex Japan index.

The point is to include dividend paying stocks in your portfolio. It could help you generate enormous returns over time.