What is a dividend and how does the compounding effect impact returns? When a company generates money they can do several different things with it:
- They can reinvest it within the company by spending on new equipment or projects, acquisitions, etc., or;
- They can return it to shareholders via share repurchases or dividends. Dividends are a distribution of the company’s earnings to its shareholders.
Similar to the compounding of interest, dividends over time can have a sizeable impact on your returns if they are reinvested in the security. By reinvesting dividends, you are purchasing shares of that security on a quarterly basis; therefore, the price per share you pay will fluctuate. The chart below shows the S&P 500 over a 20-year time frame on just a price return basis in grey and on a dividend reinvested basis in blue.
For investors, two key aspects of dividends that should be top of mind are their predictability and sustainability. You want to focus on the companies that have had a history of paying dividends and also have the ability to generate enough money to sustain and even grow that dividend over time.
The S&P 500 Index is unmanaged and is not available for direct investment. Performance of the index does not reflect the expenses associated with the management of an actual portfolio.
