David Prosser explains how reinvesting dividends makes a huge difference.
Where do your returns come from when you invest in the stock market – in the shares of the companies that trade on that market, that is? It’s actually a more difficult question to answer than you might think.
Sometimes you make money because the company performs strongly, becomes more valuable and its share price rises accordingly. Sometimes you make money because the company shares some of its profits with its shareholders by paying them dividends. And sometimes the two ideas are linked – when investors expect a company to pay out more generous dividends, demand for its shares tends to rise, which pushes up the price.
Generally speaking, however, investors underplay the contribution that income makes to the returns on offer from the stock market, particularly over the longer term. An analysis just published by Fidelity International shows that over longer periods, investors may be able to double the return they make from the stock market if they are prepared to reinvest their dividends.
Crunching the numbers
Fidelity’s numbers show that if you had invested £100 a month in the FTSE All Share index over 10 years to the end of June and chosen to take the income, you would now be sitting on a savings fund worth £15,626. But if you had opted to reinvest those dividends instead, your portfolio would now be worth £18,977 – that’s £3,351 more.
Over 20 years, the difference in the value of the two portfolios is even greater. If you had taken the income from your investments, you would now have a portfolio worth £34,522. By contrast, if you’d reinvested your dividends, your fund would have grown to £50,811. And over 30 years, the portfolio would have grown to £71,877 if you’d taken the dividends, but to £143,443 assuming you chose to reinvest – that’s very nearly twice as much.
The impact of reinvesting income is so dramatic for two reasons. First, companies are keen to pay decent dividends to their shareholders – the yield on the shares of the 100 largest companies in the UK currently stands at around 4 per cent. In other words, you’re earning £4 income a year for each £100 of shares you own. Second, compound investing is a very powerful phenomenon over the long term – each time you reinvest dividends, you’re buying more shares on which to earn more income and gains. Over time, the multiplier effect here is huge.
How to benefit from income reinvestment
If, like most stock market investors, you’re investing in shares through collective funds, rather than picking and choosing your own holdings, how do you ensure you can benefit from the dividend reinvestment trick?
Well, the first point to make is that some investors depend on the income they earn on their stock market investments. If you’ve invested in a fund paying above-average levels of income because you need that yield, it’s worth noting that Fidelity’s data shows it is still possible to make long-term returns from the stock market while taking dividend income.
If, however, you don’t need this income in the short term, it makes sense to ensure it is going back into your investments. That might mean investing in a fund that doesn’t pay out some or all of the income it receives from its portfolio. Or you could simply use each dividend you receive to make an additional investment in your fund.
Alternatively, many investment companies offer dividend reinvestment plans; these automatically use the income paid by the fund to buy more shares in it on your behalf. It’s a very convenient way to ensure you’re maximising your returns – and really getting the benefit of long-term dividend reinvestment.