Can dividend investing beat the S&P 500 index, you ask? In this post, I will break it down for you and show that it is possible with a few caveats. I will also tell you the reasons why dividend investing may not be for you.

S&P 500 and Dividends

Dividend stocks are valuable for their income stream and modest capital appreciation. The 2023 research note by S&P Global shows that dividends contributed 32% of total returns for S&P500 since 1926. The remaining 68% came from capital appreciation.

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But these are average numbers. The dividend contribution percentage varied a lot depending on the period of time.

For instance, the dividend contribution was rather insignificant in the last 20 years. Why is that? My explanation is that the proportion of tech growth firms with no dividends in the S&P 500 increased. Here are the top 10 companies in the S&P 500 in 2023.

We see that their yields are below 1% or non-existent. But, what they lack in dividends, they make up in capital appreciation. Warren Buffett once opined on dividends. He said that reinvesting in business generates more value for shareholders than paying dividends.

The average dividend yield of the S&P 500 index fell from 3%-4% in pre-2000s to 1%-2% during post-2000s. And this correlates with my hypothesis.

Next, dividends had significant contribution to compounded total returns. This is especially true over a long-term horizons. For instance, S&P Global analyzed data from 1971 through 2023.

They conclude that the 5-year price return was 50.02% without dividends. The 5-year compounded total return with dividends reinvested was 73.88%.

Similarly, the 10-year average price return was 116.89%, while the 10-year total return was 194.20%. So the difference of 77% in return was thanks to recurring dividend income and reinvestment. We see that dividends were an integral part of total returns, at least in the past.

S&P 500 Dividend Aristocrats Index vs. S&P 500

Furthermore, S&P Global constructed an index called the S&P 500 Dividend Aristocrats. The index consists of S&P 500 stocks that increased dividends for 25+ consecutive years.

From 1998 through 2023, the S&P 500 Dividend Aristocrats index’s average yield was about 2.5%, while that of S&P 500 was 1.75%. So, the yield differential was about 0.75%. The current dividend aristocrats index yield stands at about 2.3%, while that of the S&P 500 is at 1.6%.

Next, let’s take a look at the average compounded annual returns from 1989 to 2023.

We see that for longer time horizons, the S&P 500 Dividend Aristocrats index outperformed S&P 500 by over 1%. This is especially true for 10-year and longer horizons. Even after accounting for volatility, the dividend index showed better risk-adjusted returns. Also, the dividend index had smaller max drawdowns.

S&P Global concluded that most of the outperformance was due to the securities selection. In other words, the dividend index had different securities within sectors. And this produced most of the outperformance compared to the S&P 500.

Is Dividend Investing Worth It?

What does this all tell us? What kind of lessons can we learn from this analysis? Should we go and invest all our money into the dividend aristocrats index fund? The answer is it all depends on your goals and actions.

1. Dividend Reinvestment Matters

First, if you prefer withdrawing rather than reinvesting dividends, your total return will likely be lower. Moreover, your portfolio can have a higher yield compared to a benchmark. In this case, your outperformance may evaporate altogether without dividend reinvestment. Of course, this assumes that other things are kept constant.

2. Regular Dividend Tax

Second, regular dividend income can entail paying regular taxes. This is true unless you are in a low tax bracket and all your dividends are qualified. If you are not sure what this means, check out my guide on dividend taxation.

Why is this important? This is important because taxes can reduce your returns by up to 20%, if you are a high-income individual. It may seem trivial at first. But over a very long-term, the power of compounding makes tax effect visible.

Conversely, investing for capital appreciation puts you in control of your tax timing. Simply put, if you do not sell, there are no tax consequences. But, you must have a long-term horizon of at least 20 years for capital appreciation to shine. You also need to be patient with drawdowns in bear markets.

3. Regime Change

Finally, the S&P 500 outperformed the Dividend Aristocrats index by over 1% for the past 10 years or so. Remember from before that the researchers concluded that this is due to the stock selection. What does this mean? It means that the high-growth no-dividend stocks propelled S&P 500 higher.

As you may know, most high-dividend stocks tend to be value rather than growth stocks. In their note, S&P Global classified stocks between growth and value groups based on certain criteria. They conclude that 60%+ of stocks in their dividend index are value stocks on average.

For all we know, investing regimes change and certain group of stocks can fall out of favor with investors. So keep these things in mind, especially when dealing with historic data analysis.

For instance, while growth stocks shined in the past 10 years, this can change. Investors may turn to value stocks with high yields again in the nearest future.

Investor Takeaways

Each investor has his or her own preferences for holding dividend stocks. For the most part, it is the allure of a steady passive income and modest capital appreciation. But, it is a mistake to think that dividend stocks cannot go down or they do not go down as much as a broad market.

With my long-term horizon, I prefer more concentrated index funds tracking Nasdaq 100. Based on my analysis, I speculate that market cap size and economic moat correlate a lot. For this reason, I prefer betting on big tech companies that are likely to grow faster than the economy.

It is okay that there are no dividends with this style of investing. Capital appreciation makes up the difference. But, your preferences and time horizon may be different from mine. And that is the beauty of investing.