How the Dow Makes Money for You

At the end of the day, investors want their stocks to produce big returns. As long as you don't need any income along the way, it doesn't really matter whether those returns come from dividends or from stock-price appreciation -- as soon as you sell, you'll reap the same rewards.

During the so-called "lost decade" of the 2000s, however, many investors started looking a lot more closely at dividends as the primary driver of total return. When stock prices stayed flat or fell even over long periods of time, dividends seemed like the only way that you could expect to eke out any return at all from your investments.

But are dividends really the key to total returns? A look at the stocks in the Dow Jones Industrials (INDEX: ^DJI) will give us some insight into exactly how much of the 30 Dow stocks' returns came from capital gains versus dividends.

The overall picture
When you look at the Dow as a whole, you have to remember that the average itself doesn't take dividends into account. Therefore, if you just compare the closing value of the Dow today versus what it was 10 years ago, you'd come up with a rise of about 30% -- but that doesn't include dividend income at all. The total return of a Dow-tracking ETF gives you a more accurate view, showing a rise of roughly twice that figure.

Looking at the overall distribution of 30 Dow stocks shows roughly the same impact from dividends and capital gains. The average Dow stock has seen its price rise by 42% over the past 10 years. When you add in the effect of dividends, though, the average total return goes up to 83% -- suggesting a very simple answer that half of returns came from dividends and the other half from capital gains.

Dividend haves and have-nots
If you look more closely at some of the individual Dow stocks, however, you get a much different picture. Consider the following:

  • Among the top-returning stocks, dividends played an important but not equal role in returns. For Caterpillar (NYS: CAT) , a bit more than a quarter of its 361% total return came from dividends, while with McDonald's, the split was closer to 70/30 in favor of capital gains. Caterpillar rose because of its foray into high-growth emerging markets, while McDonald's remade itself into a rejuvenated force in fast food. For both, growth made dividends less significant by comparison.
  • With the worst-performing stocks, dividends weren't able to offset the effect of price declines very well. Alcoa's (NYS: AA) dividends added only 6 percentage points back to its 73% price decline, while Bank of America (NYS: BAC) could improve its total return by only 8 percentage points from its dividends. Both Alcoa and B of A suffered greatly during the recession and market meltdown, and neither has come close to fully recovering.
  • In general, the weaker the total return, the more important dividends were in producing that return.

As examples of that last point, take a look at the most extreme case in the Dow: Verizon (NYS: VZ) . The telecom giant saw a very tiny decline in its share price over the past 10 years. But when you factor in dividends, you see that they produced an 81% total return -- almost enough to bring Verizon back to the Dow's average. AT&T shows the same general phenomenon, with a 6% stock-price rise turning into an 80% total return including dividends. Both show how, with the headwind of huge capital investments holding share prices down, investors can still post decent long-term returns with dividends.

What to take away
These results show that dividends are clearly an important part of the return in any diversified portfolio. Without dividends, some of your weaker-performing investments won't be able to produce any return at all.

But neither are dividends the end-all, be-all of investing. With most of your big winners, capital appreciation will be the big driver of total return, with any dividends a stock may pay being icing on the cake.

When you're trying to decide which stocks to invest in, be sure to look for healthy dividends and the potential for share-price growth. Only the best combination of both factors will give you the extraordinary returns that every investor strives for.

If you're looking for dividend-paying stocks that may fit the bill, look no further. The Motley Fool's special report on dividends will point the way to nine promising stocks for income and capital gains. A free look is just a click away.

At the time this article was published Fool contributorDan Caplingerlikes returns any way he can get them. You can follow him onTwitter. The Motley Fool owns shares of Bank of America.Motley Fool newsletter serviceshave recommended buying shares of McDonald's. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Fool has adisclosure policy.

Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

Read Full Story