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Are dividends better than interest?

February 14, 2020

reading time: 3 minutes

by Stephan Lehmann-Maldonado, guest author

Dividends: the better interest?

Many investors get a thrill out of share price fluctuations. But in addition to the ups and downs of the stock markets, they should also pay attention to dividends.

John D. Rockefeller (1839-1937), whose name is today still synonymous with immense wealth, is stated to have said: “Do you know the only thing that gives me pleasure? It’s to see my dividends coming in ...”. Unlike many investors who only focus on a share’s price on the stock market, Rockefeller knew the importance of the dividends that companies pay.

And dividends do indeed play an important role in shareholder returns. Here is an example: since it was first published, the value of the German DAX stock market index has increased thirteen-fold – from 1000 points at the end of 1987 to 13,236 index points at the end of December 2019. The DAX, which is considered a sentiment barometer for the German stock exchange, is a performance index. It not only reflects the share price developments of the 30 largest listed companies in Germany, but also includes their dividend payments in its calculations – under the assumption that they will be reinvested in the DAX.

Like many indices, the DAX has a little brother: the DAX price index. It consists of the same companies, but only reflects their share price development. With 5910 index points at the end of December 2019, it is not even half as high as the better known DAX performance index.

A closer look at returns

So what does this difference tell us? That a large part of shareholder returns is attributable to dividends. It is thanks to dividends that one euro that flowed into the DAX around 31 years ago turned not into six euros, but into over 13 euros.

But let's take a closer look at the DAX’s incredible rise: according to a study by Hamburg-based Sutor Bank, between 1987 and the end of 2018, share price developments alone brought investors an average annual return of 5.2 percent. Dividends improved this return by 2.7 per cent, which amounts to an average annual return of 7.9 percent. At first glance the contribution made by dividends appears modest. But if the dividends are consistently reinvested in the DAX, the compound interest effect comes into play, which more than doubled revenues over the long term.

Regardless of which stock market you look at, dividends usually account for around half of total returns. And the same applies to many individual shares. That's why there are dividend hunters, who focus on shares with high dividend yields. These ensure returns and serve as a cushion against possible share price losses even when stock markets are stagnating.

Dividends instead of interest?

In 2019, many European companies paid record dividends to shareholders. Interest rates, in contrast, are persisting at record low levels, which is why savings accounts and bonds are generating hardly any returns.

So are high-dividend stocks therefore more suitable for generating returns than bonds? Unfortunately, there is no one answer to that question. On the one hand, dividends are not guaranteed and like stocks, are subject to considerable price fluctuations. On the other hand, the dividend that a company pays today is not decisive in the long term. Much more important is that a company has a solid business model, which enables it to pursue a consistent dividend policy.

But not every company that is stingy with dividends, is short on cash. Berkshire Hathaway, the conglomerate holding company headed by the stock market guru, Warren Buffet, for example, never pays dividends. Buffet is convinced that the benefit to shareholders is greater if his company invests its profits itself. In addition, unlike dividends, capital gains are not taxed in most countries. It's hard to say, therefore, whether Rockefeller would also have been a fan of Buffet.

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