In a previous post on dividend investing I mentioned why I choose to invest in dividend stocks. Its simply because of the higher long term compounded returns (see here for details).

Today I’ll discuss another reason to own dividend paying stocks – they protect your portfolio during bear markets.. Or, in other words, they increase your returns during bear markets vs non-dividend paying stocks.

First, lets make a simple model of a bear market. As I have stated earlier my investment outlook calls for another 10yrs of zero return for the S&P500 from today’s levels, which would also be about the same level it was in 1998! We’re not Japan but we’re sure getting closer. For this analysis, I’ll use a pretty pessimistic model, that has a 50% loss in year 1, followed by 4 flat years, then a steady increase back to where it started. If I took a $100 portfolio it would look something like this;

Now lets look at the annual returns of different portfolios using this market model.

The table shows the annual returns for portfolios with different initial dividend yields and different dividend growth rates. Lets start with the obvious. If you have a portfolio in stocks that pay no dividends and no dividend growth you will make no money, zero returns, for ten years. That’s row #1 in the table.

Next, lets look at what the market return would be. The market, e.g. the S&P500, currently yields about 2% and dividend growth can be around 5% per year (I think this forecast is generous but lets give the market the benefit of the doubt). The annual returns from this market portfolio would be 4.01% per year, the cell shaded green in the table. Even in this flat environment, the index would give you 4% per year. Not bad, better than a 10yr US Treasury and certainly better than the much vaunted growth stocks in such a market.

Now, look at the cells shaded yellow in the table. These are returns I consider quite feasible to achieve by picking quality dividend stocks. Its my target zone. Take a 4% yielder with 5% div growth, not hard to find at all in today’s market (DEO for example). Such a stock would give you annual returns of 8.01%, double the market return, over this terrible future time period. That’s about the long term nominal stock market return! Even a 3% yielder with 10% growth, like JNJ, would give you annual returns over 7%.

On the other hand, consider higher dividend yielders like those with 6% yields and 5% div growth. The annual returns would be 12% per year! 6% yielders with dividend growth are harder to come by but they are out there. Consider maybe the best stock of all time, Altria (MO). Good yield and good dividend growth.

How does this all work? How can you get increased returns from dividends when the market tanks and then returns to just flat over 10 years? Its quite simple really. Its because of the power of re-invested dividends. When you re-invest dividends you buy more shares the lower the price. That first year when the market tanks 50% you buy twice as many shares as you would have had the market not moved. When the market does recover the returns on those shares bought at lower prices is much greater than the return on your initial purchase. And those returns compound over time.

In summary, despite a lousy market environment you can still make great returns through the power of dividends. They enhance and protect your portfolio even in bear markets.