Equity investors had a tough time in 2022 as stock markets came to terms with a challenging global backdrop. Add to this ongoing geopolitical uncertainty and still-high inflation, and it’s no wonder that many investors are questioning how their equity portfolios can weather this forbidding investment environment.
Whether it’s in the equity sleeve of an investor’s portfolio, or more broadly as part of a multi-asset solution, one simple – and often overlooked – way of bolstering their equity investments is by harnessing the power of diversified dividend streams to help drive long-term performance.
The bedrock of long-term returns
Dividends can play a crucial role in driving long-term equity returns. This is even the case in stock markets which have traditionally been considered growth-led, such as the US. The chart below highlights the importance of dividends when compounded over long time horizons for the S&P 500 index – and the contribution of dividends may surprise some investors.
Contribution to long-term total returns in the US equity market
Source: Vanguard
For example, over the 20 years to 31 October 2022, 39% of the total returns generated by the S&P 500 index derived from reinvested dividends.
In the UK, the role of dividends has historically been more prominent, partly because UK companies have traditionally maintained generous payout policies to accommodate certain institutional shareholders (such as pension funds and life insurers) who prize long-term income more than other types of investors. Here, reinvested dividends made up 67% of total returns over 20 years.
Inflation-proofing portfolios
One reason why diversified dividend exposure is so powerful in generating returns is down to dividends’ long-run ability to beat inflation. With persistently high inflation – and the co-ordinated efforts of central banks to contain it – remaining a major theme for investors to tackle in 2023, dividends have demonstrated robust inflation-busting properties over long time periods.
For instance, in the US, dividend growth has outpaced inflation by 5 percentage points over the 20 years 30 October 2022 and 2.1 percentage points over 100 years, as the below chart shows.
Annualised growth of US dividends and inflation
Source: Vanguard
In the UK, while the real growth of dividends has been less stellar than in the US, dividend growth has nevertheless outstripped price growth by 0.6 percentage points over the 20-year time horizon to 31 October 2022. Over the long term, even modest real growth in dividends can compound significantly if reinvested.
As we explore elsewhere, for investors looking to generate a positive real return over a very long horizon, equities – especially if globally diversified – provide the best probability of beating inflation.
Beyond their inflation-proofing properties, dividends can offer a significant boost to an investor’s total returns, if they are ploughed back into equities and compounded over the long run. In our view, the best way to get the most from dividends is to reap distributions from a broad base.
Harnessing diversified dividend reinvestment
Broad equity index exposures that offer access to diversified dividend distributions can offer long-term investors a defensive quality that some more concentrated equity strategies may lack. By capturing and reinvesting seasonal dividend payments across all the major equity markets, broad index exposures compound these dividends into higher total returns over the long term.
And during equity market downturns, dividends – even if they are reduced by some companies – are reinvested at discounted valuations, which can amplify the compounding and boost long-run total returns once the equity market rebounds. The longer the investment horizon, the greater this snowballing effect of dividends on total returns.
Boosting long-term total returns
In addition to their contribution to long-term total returns, our research suggests that broad allocations to global dividends can also help investors to avoid value traps – where a company’s low valuations are underpinned by weak fundamentals – where more concentrated dividend strategies may not.
Viktor Nossek is head of investment and product analytics at Vanguard Europe. The views expressed above should not be taken as investment advice.