Total Return With Dividends Reinvested – It’s All a Myth!

Before we dive into the details of probably one of the most misunderstood performance topics out there, let’s quickly talk about what a dividend is.

What is a Dividend?

When you invest in a company and it earns a profit, the company will decide whether it wants to 1) reinvest its earnings back into the business or 2) pay its shareholders, the people own shares of the company, a dividend.  If you want more background on this topic specifically, check out this post by financial guru Mr. Money Mustache.
Shareholders like dividends because it is a source of income. It serves as money in your hand now versus having to sell shares of your stock.
Now that you (a shareholder) got a dividend, what can do you do with it?  Well, you can 1) take the cash and save it, 2) take the cash and spend it, or 3) not take the cash, and instead reinvest it in more stock.
In scenario 3, you do not cash out and instead automatically buy more stock with your dividends.  In other words, the money never leaves your investment portfolio.  If you are an individual investor, you probably have this option on your trading platform (e.g., Fidelity, Vanguard).  If you work for a professional investment manager and are managing money on behalf of clients, then you probably have an accounting system where this option can be chosen.
Many people choose to reinvest their dividends because reinvesting helps your investments grow faster. This is compounding at its best.
So, if dividends help your investment grow, how do they affect your returns?
While it is completely true that you will have more dollars in your investments by reinvesting dividends, it doesn’t necessarily mean that your return (measured as a %) will show that.
Myth: Reinvesting dividends increases your returns.
Truth: Your investment return (%) reported on your monthly, quarterly or annual statement will typically be the same regardless of whether you reinvest your dividends or not.
Why?
In a nutshell, returns try to summarize how your investments did, regardless of when you take money out of your account.
Example: You invest $100 and then remove $2 from your account to spend
You start with $100 and your ending value is $98. You withdrew $2 during this time period.  Your gain/loss and return will be calculated as:
Gain/Loss = What You Ended With – What You Started With – How Much You Withdrew or Added
$98 – $100 – (-$2) = $0
Return = Gain or Loss / What You Started With
Return = $0 / $100 = 0%
Think about this – your account did not drop due to a loss on your investments.  It dropped due to the fact that you took money out.  So your gain/loss on the investments is $0 and your return would be 0%.
This is the same thing as a dividend that is taken out of the account.
Example 2: You invest $100 in a stock that pays a $2 dividend; you cash it out to spend it
If you start with a stock that is worth $100 and it pays a $2 dividend, the stock will theoretically be worth $98 after the dividend.  So you will have $98 worth of stock and $2 of cash.  If you take the $2 out of the account, your gain/loss and return will be calculated as:
Gain/Loss = What You Ended With – What You Started With – How Much You Withdrew or Added
$98 – $100 – (-$2) = $0
Return = Gain or Loss / What You Started With
Return = $0 / $100 = 0%
Now let’s see what your return will be if you reinvest the $2 dividend.
Example 3: You invest $100 in a stock that pays a $2 dividend; you choose to reinvest it
Similar to scenario 2, you will have $98 worth of stock and $2 cash after the dividend pays.  However, that $2 is automatically used to buy more stock so you have $100 in stock and took no cash out.  Your gain/loss and return will be:
Gain/Loss = What You Ended With – What You Started With – How Much You Withdrew or Added
= $100 – $100 – $0
= $0
Return = Gain or Loss / Beginning Market Value
Return = $0 / $100 = 0%
Ah-ha!  So it’s a 0% return as well.
So you can see by these 3 examples that if you reinvest the dividends, you do end up with more money in investments – you have $100 instead of $98.  However, your return is the same under both scenarios.  We dispel the myth that your returns are higher when you reinvest dividends.

Two notes:

  1. We are discussing time-weighted returns here, the internal rate of return would be somewhat different, but time weighted return is the most common with the disclosure “returns reflect reinvestment of dividends” which does not make sense.
  2. Returns with dividends are higher than returns without dividends (called “price only” returns).  But that is different than saying returns are higher when you reinvest dividends versus when you don’t, which is not true.

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