The Importance of Dividends and Why You Should Use DRIP

Following up on our previous post explaining e-series and how they offer a DRIP program (Dividend Reinvestment Plan). In this blog post, we will analyze the importance of reinvesting dividends for long term growth. Dividends are an important portion of your earnings, they represent your only earnings that are ensured within the market a given year. Dividends fluctuate over time, for example, during the market crash of 2008, many companies that were historical dividend payers cut their dividends in order to retain funds for recovery. Here are the current dividend payout of four common e-series index funds:

TDB900 - Canadian Stock Index

(.531/20.67)*100 = 2.57% (variable, annually)

TDB909 - Canadian Bond Index

(0.034/11.71)*100 = 0.290% (variable, monthly), or 3.48% (annually, assuming no compounding).

TDB905 - International Stock Index

(0.213/8.78)*100 = 2.43% (variable, annually)

TDB902 - U.S. Stock Index 

(0.745/46.99)*100 = 1.59% (variable, annually)

Sample Equation:

(last distribution/current price)*100= dividend % (or interest, in the case of bonds)

Note that these are variable and the percentages are a function of the current price and the most recent payouts (which was throughout December 2015 for the three stock index and on January 29, 2016 for the bond index). The payout itself is dynamic as it can change depending on the characteristic of the index portfolio, but also if companies within the portfolio change their dividend payouts (for better or for worst). The bond index is the only one to payout monthly, currently at a rate of 0.29%/month or 3.48%/year (if not reinvested); if DRIP is used, effective annual interest rate would actually be around 3.54% due to compounding. Note that for the bond index it is interest, not dividends, that you are receiving. 

Now let's assume you have the following portfolio allocation:

30% Canadian Stock Index @ 2.57% dividend yield

15% Canadian Bond Index @3.54% dividend yield (compounded monthly)

25% International Index @ 2.43% dividend yield 

30% U.S. Stock Index @ 1.59% dividend yield

You would obtain an average dividend yield of around 2.39% per year. On a $10,000 investment, this amounts to $239. Not so bad for earnings from dividends alone! Assuming you made no additional contributions to your portfolio, the following year you would stand to earn even more due to compounding.

Now lets assume your $10,000 investment somehow remains completely stagnate in market value over the next 50 years (and assuming yearly re-balancing), here is how your 2.39% dividends would compound:

Compounding Dividends Impact

$ amount (year)

239.0 (1)

244.7 (2)

250.6 (3)

256.6 (4)

262.7 (5)

302.7 (10)

383.3 (20)

485.4 (30)

778.5 (50)

Your initial $10,000 would now be a portfolio valued at $33,353 due to DRIP alone! Had you not used DRIP over the complete 50 years, you would've earned 50*$239= $11,950 - but by reinvesting dividends, you have now accumulated $23,353 in dividends, or 95.4% more money! While using a 50 year time scale is a bit extreme, it depicts the power of compounding interest by using a dividend reinvestment program. Click here to view the complete breakdown.

Let's look at a more concrete example relating to e-series. Below are two graphs that show how $10,000 would've grown in the U.S. stock index (TDB902) over the last 10 years with or without DRIP.

Case A: TDB902 last 10-year return with DRIP

Source: TD Canada Trust

Case B: TDB902 last 10-year return without DRIP

Source: TD Canada Trust

This indicated a difference in portfolio value of $21,742 - $18,284 = $3458, or a portfolio worth 18.91% more. In the second graph, the investor still received dividends but decided not to reinvest them. If we focus on the last term on the graph, and taking the current 1.59% dividend yield, investor in case A would make $345.70 in dividends, while investor in case B would only make $290.72. This difference again would continue to magnify over the years as investor A would enjoy compounding growth while investor B would not, as depicted in the prior example.

Reason to use DRIP:

• Allows your dividends to compound year after year
• Free program (e-series)
• Easy to set up
• A great way to contribute annually to your investments

For long term investors, there's really is no good reason to not be using the DRIP program if it is available and free, so I suggest you do so! If you have any questions regarding dividends or DRIP programs, please ask below!

-Yinvestors.

Note that dividend section was written in relation to the price and payouts at the time this article was written, please view this TD page for up-to-date prices and payouts for index and mutual funds. 

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