Dividends vs. Capital Gains: Which is better?

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With the latest market declines reminding us anew of the inherent risks of stocks, it’s a good time to re-examine  how the stock market creates wealth. There are all sorts of wrinkles but it all really comes down to two big things: Stocks either rise in price (capital appreciation) or companies pay out a portion of profits (dividends). Collecting dividends can be a boring way to accumulate wealth, but it’s pretty effective. The folks at Morningstar/Ibbotson have stock market data going back to 1926. Over that time (1926 through 2009) stocks have provided an annual average return of 9.81%. Of that return, the Ibbotson data show, capital appreciation accounts for 5.47 percentage points,  a bit more than half. Dividends, however, are not far behind, delivering 4.13 percentage points.

Some of you will quickly notice that the two components do not precisely add up to 9.81%, which owes to statistical noise and rounding over many decades of data. But the big point remains: Dividends are the unsung hero of the stock market and in many ways the more reliable provider of wealth. Of course all that could change if the tax treatment of dividends changes dramatically in the years ahead, but that’s a calculation everyone has to do for themselves.

So is investing for dividends a better way to increase your nest egg? That depends on the economic environment. Given the current global uncertainties stocks could remain listless, giving dividends a leg up.

Brian Belski, the chief strategist at Oppenheimer & Co, is out today with a new report singing the praises of companies with high dividend growth. The firm looked at stock performance from 1990 to the present, and concludes that “companies with consistent dividend growth significantly outperform those with little dividend growth.”  Here are the numbers: The top quintile of dividend growers returned 12.5% while the lowest quintile returned just 4.6%; the overall S&P 500 returned an  annual average of 5.7% over this period.

The bottom line for investors, says Belski, is to focus not just on companies with healthy dividend growth but on those that also have robust growth in underlying cash.

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