To buck the trend in most articles titled with a question I’ll actually answer it: no, a dollar of dividends is worth the same as a dollar of capital gains. However, that didn’t stop a commenter, Rob, on a Canadian Couch Potato post from arguing differently. Please note that the Canadian Couch Potato himself was on the correct side of the math on this question, although he had the good sense to spend less time arguing with Rob.
Rob’s argument ran as follows. If you had invested $100 in the UK stock market in 1945, it would have grown to $7401 by 2011 if you lived the good life and spent all the dividends. However, if you had reinvested the dividends, you would have $131,469 by now! The return in this case is 18 times higher than the returns due to capital gains alone. So, this must mean that the dividends must be worth 17 times more than the capital gains.
We could take this a step further and observe that the average compound return in the UK stock market due to capital gains and dividends are 6.7% and 4.5% per year, respectively. Amazingly, even though the return due to capital gains is higher, the dividend return is worth 17 times more. This makes a dollar of dividends worth about 25 times more than a dollar of capital gains!
Of course, all this is nonsense; a dollar is a dollar. There can be differences due to taxation, but if we stick to thinking about tax-advantaged accounts like RRSPs and TFSAs, all dollars of return are equal.
We could just as easily have imagined an investor who gave away enough shares to charity each year to eliminate his capital gains and then reinvested his dividends. In this case, the original $100 would have grown to only $1776. Now we can say that the dividends only produced a return of $1676, but the capital gains and dividends combined produced a return of $131,349. So, the capital gain returns are worth 77 times more than the dividends. On a per-dollar basis, capital gains are worth 52 times more than dividends.
Of course, this line of reasoning is nonsense as well.
At its core, we can simplify the mistake with this logic into the following little story. Justin starts with a 1-inch by 1-inch piece of pizza (one square inch). If he extends it to 20 inches long, then he adds 19 square inches. But if he then extends the width to 10 inches, he adds 180 more square inches. So he reasons that width is more important than length. His friend Jim extends the width first and length second and concludes that length is more important. But, both are mistaken because length and width are equally important in determining area.
The moral of this story: don’t let people with bad math confuse you about investing.
Well put, dividends are very nice, especially the ease of reinvesting them, however, as your explanation says, you are adding to the principle, there is no Magic Dancing Monkeys here.
ReplyDelete"don’t let people with bad math confuse you about investing."
ReplyDeleteI think I'll get some T-shirts made up with that slogan...
@Big Cajun Man: It definitely takes some dancing monkeys to make it seem like some dollars are worth more than others.
ReplyDelete@Potato: Glad you liked that one.
@Mike: Thanks for the link, and for explaining the math more clearly than I could. Really, the takeaway message from the data is simply that compounding is powerful, so it's better to reinvest your dividends rather than spend them.
ReplyDeleteBy the way, I think the consensus is that width is indeed better than length.
@Canadian Couch Potato: That's hilarious. I didn't even see the width/length joke when I wrote the post. This reminds me of kidding a friend who uses golf balls marked "long and soft". He says "at least it's long."
ReplyDeleteCompounding is very powerful, maybe that was the argument "Rob" was trying to make? Who knows I guess...
ReplyDeleteEither investors want capital appreciation and some yield (indexing) or they are taking more yield with some capital appreciation (dividends), all things being equal. Of course, to do the latter with dividends, you need to own all those stocks individually, so there will always be a risk premium but that drops off with the more stocks you own.
I'm going to read Rob's comments on CCP now.
I won't start with all the golf metaphors...that could be an entire blog unto itself :)
@Mark: Rob said enough to make his meaning quite clear as you'll find out.
ReplyDeleteWhen the time comes, I'll be happy to generate part of my retirement income from selling shares rather than seeking high-dividend stocks.
I'm not sure if your use of "risk premium" is just a slip, but I'll launch into an explanation anyway. When a portfolio is insufficiently diversified, it suffers volatility losses. "Risk premium" is the higher expected return of a risky investment compared the the return on a safe investment. So, risky assets enjoy a risk premium, but compounding effects over time produce volatility losses if a risky portfolio is insufficiently diversified.
Maybe I'll start a second blog devoted to golf metaphors!
"you would have $131,469 by now"
ReplyDeleteActually, you wouldn't. You'd have an asset worth that much based on market value. You'd only have that in your pocket if you sold the asset. During that same period used in the example, the dividends received would be real money received. You would have received $0.00 in capital gains during the same time if the asset was still held. How can they be worth the same?
You can only hope that it would be worth that much when ready to sell, and not during another year like 2008.
@Al Cesar: Keep in mind that the $131,469 figure comes from reinvesting dividends. So, the investor who has this much stock has $0.00 cash in his pocket. If he had kept all the dividends as cash, he have stock valued at $7401 plus cash in his pocket of less than $10,000. So, if you've got stocks lying around with market value of $131,469, I'd be happy to take them off your hands and give you the much more valuable "real money" of $10,000.
ReplyDeleteLove the comments.
ReplyDeleteOf course dividends are worth infinitely more than capital gains or any other kind of income. Why? Because they are. It's not for mortals like us to question things like that. ;)
@Mike: I find it interesting that I sometimes find myself in the role of arguing that dividends aren't magical. Readers could be forgiven for thinking that I'm against dividends. In fact, I'm quite happy to see dividend cash dumped into all my trading accounts each quarter. But, I know that each dollar of capital gains is worth just as much as a dividend dollar. But, none of these arguments mean much in the face of someone who has adopted dividends as a religion.
ReplyDeleteI loved that length/width analogy until Dan came along and sullied it.
ReplyDelete@Patrick: I like it even better after Dan's take. He's a funny guy.
ReplyDelete@Canadian Capitalist: Debunking this sort of nonsense can get frustrating. I remember dealing with an insurance salesman who was quite challenged at determining which of two numbers is greater. I had a term life insurance policy that cost me something like $40/month. I told the salesman I'd talk to him if he could find a way to lower it for the same coverage. He then started showing me various mixes of term and permanent insurance, but they were all more expensive. But he didn't seem to want to admit it. I would say, "you know, I'm pretty sure that $75 is more than $40." Then he'd launch into another pitch that ended with a number bigger than $40.
ReplyDeleteThe comment above is a reply to Canadian Capitalist's comment:
DeleteOne hears the dividends-have-supplied-80-percent-of-returns nonsense from experts all the time too. Since, when is 8 > 5 a big surprise?