Einstein was right – it pays to reinvest dividends
IT’S difficult to turn on the television at the moment without seeing a computergenerated image of Albert Einstein sitting in a bath pontificating about t he benefits of smart meters. only mention him because he is pertinent to the subject I am writing about: the power of compound interest, especially in the world of investing. It’s a financial phenomenon that the great man had a view on. He described it as the ‘eighth wonder of the world’, adding: ‘He who understands it, earns it...he who doesn’t, pays it.’
As Einstein implied, compound interest can be a financial force for both good and bad. So, receive interest as a saver – fat chance mind you these days – and provided you don’t withdraw it, the sum will be capitalised soon after it hits your account. So £1 of interest received on a £100 savings balance results in a new balance of £101. The next time, interest is paid into your account, it will be earned on £101. In effect, interest on interest – compound interest.
Sadly, if you’re a borrower, the compound tables are turned against you. If you’ve got a credit card debt and cannot clear it, interest will start to compound. As a borrower, you will be paying interest on interest.
But it’s the positive side of compounding that I want to concentrate on. This is because when it comes to generating long-term investment return, compounding – through the automatic reinvesting of dividends – can be transformational.
For example, if we look at the UK stock market – in normal times, a rich provider of dividend income – if someone 30 years ago invested £10,000 in the MSCI UK Index they would now be sitting on an investment worth nearly £26,160 in share price terms. An annual investment return of 3.25 per cent.
BUT if they had reinvested all the dividends from this investment as soon as they were received – rather than squirrel them away in the bank – their £10,000 investment would now be worth more than £49,550. In other words, an annual investment return equivalent to a tad below seven per cent.
Similarly, dividend reinvesting has rewarded i nvestors handsomely in the United States. Looking at the Standard & Poor’s 500, a £10,000 investment made 30 years ago in this leading stock market index would now be worth more than £138,700 in share price terms. But if dividends had been automatically reinvested, its current value soars to just over £256,000.
‘In many cases, reinvesting dividends is a no brainer,’ says Arlene Ewing, investment expert at wealth manager Brewin Dolphin. ‘It is the ultimate way of delivering compound returns.’
It’s a view shared by Jason Hollands, a director of wealth manager Tilney. ‘If you don’t need to draw the income from your investments, then reinvesting dividends is a very sound move. In fact, over the long term, it can reinvigorate returns.’ Although the investment numbers just quoted support the long-term case for reinvesting dividends, they do not paint the whole picture. The calculations ignore the dividends that an investor would have received had they chosen to take income rather than reinvest it (closing the gap between £26,160 and £49,550, and £138,700 and £256,000). Also, reinvesting is not an automatic win-win. In conjunction with wealth manager AJ Bell, The Mail on Sunday has looked at the effectiveness of reinvesting dividends for 20 popular UK shares ( see table) over the past ten years. We have calculated the current value of £10,000 invested in each of these companies under two scenarios.
First, where dividends have not been reinvested but instead squirrelled away in a bank account. So, an investor’s return comprises a mix of share price return and income. We have assumed no interest has been earned on the banked dividends. Second, where dividends have been automatically reinvested. Here, we have assumed that the reinvesting has been done charge-free although in practice this would not be the case.
The results confirm that reinvesting dividends has resoundingly added value. An initial investment of £200,000 across the 20 companies is now worth £427,565 under the first scenario, but £475,889 with dividends reinvested. Of the 20 companies analysed, dividend reinvesting has added value in 15 cases.
‘Overall, reinvesting dividends has been a winning strategy,’ says AJ Bell’s Laith Khalaf, who did the number crunching. ‘This is particularly the case where dividend payments have been high and the share price has also performed well over the ten years.’ But he adds it has not proved fruitful where companies’ share prices have fallen.
Fidelity International’s Tom Stevenson says that in order for compounding to ‘supercharge’ investment returns, it requires two
The earlier you start with this strategy, the better
ingredients: ‘time and the regular disciplined re investment of income’. In other words, the earlier you start, the better.
It’s a point reiterated by Brewin Dolphin’s Ewing. She says: ‘If you are in your 20s or 30s and starting off investing, reinvesting dividends can be a good way of delivering greater growth in a portfolio. But if you’re approaching retirement or have stopped working and need the income, it is not the right option.’
For those, like Einstein, who are convinced by the magic of compounding, ensure your portfolio is set up to reinvest dividends on any shares or trusts held. If you hold funds, check that they are accumulation, not income, units.