Survivorship Bias
One of the most important concepts in all of investing is “survivorship bias”. Per wikipedia:
In finance, survivorship bias is the tendency for failed companies to be excluded from performance studies because they no longer exist. It often causes the results of studies to skew higher because only companies which were successful enough to survive until the end of the period are included.
You should view any sort of “theory” on stock selection such as value, small-cap, growth, or dividend payers (generally part of the “value” spectrum) as a “sales pitch”. When someone tries to sell you on something, they will use whatever data that is available to support their pitch.
The data that is generally available is in the stock market “raw” data. You can see the price changes, the dividends, and compare these against your selected group or theory in a variety of ways.
Valuing Dividends
In general, it is more difficult to determine total stock returns (i.e. how successful your proposed theory is) when you include dividends. It is easy to look at the “price” of a stock from 10 years ago and the price of that same stock today and said it “went up 25%” or “went down 25%”. Or, if you owned that stock and are looking for it, that the stock doesn’t exist in the index any more (it went bankrupt, merged with someone else, or went private). Even large and sophisticated investors sometimes forget to include dividends in their calculations.
Dividends are harder because they are payouts to shareholders and then you need to determine what happened with those dividends. For my trust funds, for example, the dividends are received in cash. Then we take the cash and re-invest it periodically, in our case annually. Thus you don’t earn a “return” on that money, other than interest (which used to be significant, but now can essentially be modeled at zero since interest rates are so low) during that time.
For most models used by analysts, dividends paid are assumed to be re-invested in shares. Thus if you receive a dividend of 2%, you essentially now own 2% more in shares, and you also earn dividends on those shares going forward, as well. To make it a bit more complicated, there are taxes that you have to pay when you receive those dividends, so you may want to reduce the effective value of those dividends by 15% (the current taxable rate) or closer to 30% if that exclusion is taken away when the tax laws are changed in 2013. Here is a wikipedia article that reviews the taxation of dividends for individuals.
Dividends are important. Per the “dividends aristocrats” methodology used by the S&P 500 and found here,
Since 1926, dividends have contributed nearly a third of total equity return while capital gains have contributed two-thirds. Sustainable dividend income and capital appreciation potential are both important in determining total return expectations.
For our own portfolios, dividends have brought in a substantial portion of total return. The impact is largest on our biggest funds, portfolio 1 and 2, since they have more stocks and a longer time frame to accumulate dividends.
