For most young investors, the period from 2009-2021 was characterised by an epic bull market in US stocks.
As a result of low interest rates and a benign macroeconomic (as well as geopolitical) environment, many growth stocks surged.
That’s because money was essentially “free”. This allowed many top growth companies to borrow at low interest rates to fund growth.
However, the picture now is starkly different. With higher interest rates and decades-high inflation, does that mean we should stop investing altogether?
Certainly not. But the way we think about allocating our money in the stock market should shift somewhat. A renewed focus on dividends may be beneficial to investors over the long term. Here’s why.
Higher rates and inflation here to stay?
There are lots of financial commentary pieces out there pondering whether the high inflation and high interest rate environment is here for good.
No one can know for certain but investing in dividend stocks has stood the test of time. That’s been true no matter what the market environment.
That’s because receiving payouts from dividends allows investors to then reinvest those proceeds back into the stock market. Naturally, that increases the pace of compounding your wealth.
In stock market terms, there are two types of returns. One is the price return (i.e. the amount by which your stock or ETF rises over time).
Then there’s the total return. This metric is much more key for investors as it measures both the price return plus the effect of dividends received.
Those dividends received and then reinvested over time have a truly remarkable effect.
The below chart from a whitepaper by Hartford Funds – a big American fund house – illustrate this perfectly.
Over the past 40 years, an amazing 84% of the total returns of the S&P 500 Index can be attributed to reinvested dividends!
Sources: Morningstar, Hartford Funds
As the graph also shows, the amount that you end up with if you reinvested those dividends is over six times what you would have ended up with if you had just focused on capital appreciation alone.
Providing a buffer in times of uncertainty
As I’ve mentioned before, dividend stocks can also provide a level of security during market volatility. For example, many stocks in the US have been paying rising dividends for 25 consecutive years or more.
Dubbed “Dividend Aristocrats”, these companies continue to pay dividends year in, year out, no matter how bad the stock market outlook is.
Dividend stocks also tend to be more mature businesses, given they can pay money to shareholder out of their cash flows.
As a result, that means in an uncertain macroeconomic environment, dividend stocks (and businesses) tend to be much more resilient than those that are loss-making or don’t have any positive free cash flows.
Focus on compounding wealth with lower volatility
Notice that I used the word “lower” and not “low” because investing in stocks is generally perceived to be one of the more volatile investable assets out there.
However, it has proven over the decades to be the best long-term generator of wealth and dividend stocks can achieve this with a relatively lower level of volatility versus, say, growth stocks.
As a result, thinking about buying into businesses which can thrive – and also pay dividends – allows us to diversify our portfolios.
It also means investors can sleep a little easier at night knowing that dividend payments (or passive income) continue to flow to us.