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Reinvestment is key to long-term growth

Buying dividend-paying stocks that increase their dividends each year, reinvesting those dividends, and, if possible, buying additional stock each month are excellent ways to achieve above-average investment returns with below-average risk.

Dividends are cash payments made to shareholders of a company's stock, usually paid quarterly. Investing in individual dividend-paying stocks is easy and can provide substantial returns over the long term.

We all have heard statistics about the stock market growing at an average of 9 percent to 10 percent over the long term. However, what isn't mentioned is that, depending on the period selected, up to 70 percent of the total returns for the period comes from dividend reinvestment, which is crucial for achieving the best return possible on your investment.

Dividends provide the more predictable part of the total return on your investment. Total return includes income and capital appreciation. Capital (stock price) appreciation, in the long term, is based on two main elements: the company's increases in earnings and sales over time and increases in the income (dividends) generated by the stock investment.

In the short term, stock prices react to speculation, buying and selling, market ups and downs, and other factors. These elements cause short-term price fluctuations but have less of an effect on long-term price appreciation than do increases in the sales and net earnings of the company and increases in the amount of dividends paid.

Also, it's important to understand the concept of dividend yield. This is a percent and is calculated by taking the annual cash dividend per share and dividing it by the stock price per share.

For example, a stock that pays a dividend of $1 per share (each year) and sells for a price of $25 per share has a dividend yield of 4 percent ($1/$25 = 4 percent).

If a stock pays a 4 percent dividend that increases each year, the amount of dividends you have to reinvest will increase. This compounds the dividend payments you receive, and the increasing dividend payments over time usually will cause the stock price to rise.

A personal example

In June 1990, I inherited 57 shares of Central Illinois Public Service (now Ameren). At a price of $21.86 per share, these shares were worth $1,246.

I did nothing with this investment except set up a dividend reinvestment plan and reinvest my dividends each year for the next 14 years. Fourteen years later, I have 136.376 shares, and at a price of $42.92 per share, they are worth $5,853.25. This is an 11.6 percent annual rate of return (compounded). The dividends started at $1.84 per share and increased to $2.54 per share. This is a rate of increase in the dividend of 2.3 percent per year. The starting dividend rate was 8.42 percent (1.84/21.86 = 8.42 percent). After starting with that rate and reinvesting those dividends, this small investment beat many stock market indexes during the period 1990 to 2004 with far less risk and volatility.

Ameren is not a growth utility, nor a particularly attractive investment. If you add the dividend rate of 8.4 percent plus the annual rate of increase in the dividends of 2.3 percent, you get 10.7 percent, which is close to the actual total return achieved on my investment. If you analyze other stocks, you will find that the beginning dividend return (or average dividend return if making periodic investments) plus the annual rate of increase in the dividends will come close to the long-term rate of return that you can expect on your investment.

Note: Stocks mentioned in this article are not necessarily good investments and are mentioned for illustrative purposes only.

Bottom Line: Buying carefully selected dividend-paying stocks with a history of increasing dividends each year, reinvesting the dividends received and making additional periodic investments can provide superior long-term investment returns with lower risk and volatility.

Barbara Pietrowski is a licensed certified public accountant, certified financial planner and personal financial specialist. Her practice includes tax preparation, fee-only financial planning and investment management. Her office is in Kensington, Md.