Compounding investment creates snowball effect

THE power of compounding investment returns can be the key to building a strong portfolio.

It is particularly significant if you intend relying heavily on dividend returns to provide for a comfortable retirement.

So the reinvestment of income distribution/dividend payments is important.

Of course these are not easy times: interest rates are low; we are seeing historically poor yields; and many businesses are under pressure.

Hence you may need to take a regular income from your investments to boost your overall earnings. Or there may be a specific requirement for an additional income stream.

But for those who don’t want or need to take income on a regular basis, the decision to reinvest back into their portfolios can have a substantial impact on investment returns over the longer term.

Helen Bradshaw, portfolio manager at Quilter Investors, notes: “For example, figures show that over a period of almost 35 years the FTSE All Share Index delivered a cumulative return (excluding dividends) of 479 per cent.

“However, if investors had reinvested their dividend income back into the market instead of taking it as income, then their returns would have jumped to an impressive 1,888 per cent.

“This dynamic exists further afield too. Over a 45-year period the MSCI World Index delivered a cumulative return of 4,254 per cent, but this jumps to 11,006 per cent had dividends been reinvested over this time.

“The evidence is equally compelling if you look at the MSCI Emerging Markets Index, which saw the total return almost double from 249 per cent to 441 per cent.

“The reason for this improvement in returns is the power of compounding. Essentially, by reinvesting income into a portfolio, the investor is buying more of the underlying investment, such as company shares.

“By holding more shares the investor then has the potential to earn more income from dividends in the future, which if reinvested then repeats the process.

“With this relatively simple technique the investor earns returns on their returns creating a snowball effect that can produce far more than they might have imagined.”

It is particularly pertinent that investors decide whether they are income takers or income re-investors.

Many may find themselves in income-based funds where the distributions/dividends are being paid into a cash facility on platforms or as consolidated income into a nominated bank account.

This may not be the most appropriate strategy for their portfolio if, for example, they are still considered to be within the “accumulation” phase and some years from retirement.

It is often much more beneficial to ensure clients are invested within these accumulation-based or growth funds in order to benefit from the compounded returns over time.

As always, investors need to keep their eye on the ball.

Ms Bradshaw cautioned: “In a world of low interest rates, some companies may be tempted to borrow in order to make shareholder pay-outs, which could be a sign of larger problems such as a weak balance sheet.

“And at times of market stress this could lead to unexpected cuts or even suspensions of dividend payments, which can affect the level of income available to reinvest or withdraw.

“This was clearly demonstrated during the global financial crisis when UK banks in particular – a key source of equity income – were forced to cut or suspend their dividend payments, resulting in total UK dividend payments falling around 13 per cent from £62 billion in 2008 to £54.1 billion in 2009.”

Nevertheless, reinvesting income for the future can build up returns relatively quickly, which can then be used to take a higher income, or to benefit from more capital growth. Trevor Law is managing director of Eastcote Wealth Management, chartered financial planners,

based in Solihull. Email: tlaw@eastcotewealth.co.uk

The views expressed in this article should not be construed as financial advice