Compare Apples to Apples When Investing (Kerry Watkins-Bradely Commentary)

How do you benchmark your investment performance? Do you use the Dow Jones Industrial Average, the S&P 500 or perhaps the technology-heavy Nasdaq?

When assessing the performance of your portfolio or a given investment, it’s always important to use an appropriate index.

If you have a portfolio that consists mostly of stocks in the Dow Jones Industrials, then it would be appropriate to use that index as a benchmark. However if your portfolio was heavily weighted toward technology stocks or small company stocks, a better gauge would be the Nasdaq or Russell 2000, respectively.

There are many ways to judge the performance of your investments. Unfortunately, many people simply look at the bottom line. Did the investment go up, did it go down, and if so, by how much?

But there’s much more to performance than that. You must also include any income generated by that investment to get the total return.

For stock investments, that’s dividends. So no matter the make up or the benchmark you use, always keep in mind the concept of total return (capital change + income).

Historically, dividend payments have made up a generous portion of the total return of stock investments, but during the booming days of the bull market back in the 1990s, dividends took a backseat as investors focused on price appreciation of stocks to provide their return. No one really cared about a 2 percent dividend yield when stock prices were gaining 20 percent, 30 percent or 40 percent annually.

As you can see from the graph below, the Dow Jones Industrial Average dividend yield has fluctuated between 3 percent (during market highs, for example in 1929) and around 8 percent (during typical market lows).

Dividend yields have been steadily declining since the early 1980s, and only in the past 15 years has the yield dropped below the 3 percent low-water mark.

This decrease in dividend yield directly corresponds to the start of the bull market that began in 1982. The retreat in dividend yield is partially due to the above average growth in stock prices throughout the bull market but also a change in sentiment of corporations.

Due to the booming economy and unfavorable tax consequences on corporate dividends, corporations found other ways of using cash to reward shareholders, by reinvesting in the business or buying their own stock back rather than paying it out in the form of dividends, but since the bursting of the stock market bubble in 2000, dividends have made a comeback.

Record low interest rates, as well as a favorable change in the tax code, have dividends getting the attention of investors once again.

Even though dividend yields have been below average for many years, they can still make a profound difference in the performance of an index or portfolio.

By any count, 2005 was not a year for the record books for the equity markets. You’ve probably seen or heard on the news that the Dow Jones Industrial Average was down -.61 percent in 2005. Well that is correct if you don’t include dividends.

The Dow actually ended the year lower than it started (10,717 vs. 10,783), but if you included the dividends, the total return on the index was a positive +1.66%.

The positive gains were attributed totally to dividends paid. The S&P 500 returned +3.00 percent in 2005 not including dividends, but if you look at total return, the S&P 500 actually did much better, posting gains of +4.86 percent. The same is true for any index.

This occurrence does not take place all that often. The last time the Dow Jones Industrial Average lost principal but remained in the black for the year was 1984 when the price movement on the Dow was down -3.74 percent for the year but the 4.8 percent dividend yield pushed the total return on the index to +1.07 percent.

When embarking on an investment program, it’s always important to establish your long-term goals. This is the true measure upon which to gauge your success.

While your portfolio or a single investment might not beat the benchmark index year in and year out, it is still important to be aware of how your investments are stacking up against the general market.

In the past several weeks, we have seen a number of money managers and mutual funds reporting only the principal movement in the benchmark indexes while reporting portfolio performance that includes dividends, which is not an apples to apples comparison.

Whichever benchmark you use to gauge your investment performance, always remember, if you want a true comparison, you need to use a total return benchmark, and always keep in mind that dividends do matter. Not including a 2 percent dividend yield, or any yield for that matter, over a number of years can really add up.

(Kerry Watkins-Bradley, CFA, MBA, is equity portfolio manager at Garrison Financial in Fayetteville. E-mail her at [email protected].)