Why it is smart to reinvest your dividends

Reinvesting dividends can help accumulate more stocks and reap the benefits of compound interest, explains Harvey Jones

Dividends are the great unsung heroes of investing, delivering most of the action but winning little of the glory.

Too many personal investors fixate on share price growth, expecting to make most of their money when markets rise over time.

The media plays up to this by reporting stock movements every second of the working day, but the real rewards lie elsewhere. Over the longer run, and investing is a long-term game, dividends will generate more than half the money you will make out of investing in stocks and shares.

Dividends are the regular payments many companies make to shareholders as a reward for holding their stock. Larger, established companies tend to be the most generous payers, to compensate for the fact that their growth prospects are lower than, say, a fast-growing technology start-up.

Dividends are typically distributed quarterly with the most generous paying between 3 and 6 per cent of your stockholding each year, a figure known as the yield.

Stock markets rise and fall, but dividends will mostly keep rolling in. However, in order to benefit, you must do this one thing.

Instead of drawing your dividends as income every quarter, you need to reinvest them back into your stock, mutual fund or exchange traded fund (ETF). That will turbocharge your returns, because you are using the money to accumulate more stock or units, and benefiting from the glories of compound interest.

Physics genius Albert Einstein once called compound interest the most powerful force in the universe, and he was only half joking.

New figures from mutual fund manager Fidelity International demonstrate exactly how powerful this force is. In many cases, it will more than double your total investment returns over the longer run.

Its figures are based on the broad-based London index, the FTSE All-Share. UK companies have a tradition of paying generous dividends and this index currently yields 3.6 per cent, compared to 1.9 per cent on the S&P 500 in the US. However, the principle applies to any investment that pays dividends.

Somebody who invested £100 (Dh478) a month in the FTSE All-Share 10 years ago would now have £15,626 if they had taken their dividends as income. However, this would rise to £18,977 if they had reinvested their dividends – £3,351 more – and the benefits compound dramatically over time.

After 20 years, they would have £34,522 if they had taken their dividends, or £50,811 with dividends reinvested, an extra £16,289.

The difference is stark after 30 years, the kind of time that most people will be saving for their retirement.

Maike Currie, the investment director for personal investing at Fidelity International, says: “Your £100 a month would be worth £71,877 but with dividends reinvested it would be almost double that sum, a whopping £143,443.”

These figures are based on a small monthly amount of

Dividends can keep the value of your investments rising even if market performance slips

£100 a month, equivalent to just US$76 at today’s exchange rates.

Take instead the case of a UAE-based investor who pays in $1,000 a month. After 30 years, they would have $718,770 if they drew their dividends, or $1,434,430 from reinvesting.

Of course that extra $715,660 is not pure profit, those who drew their dividends would have had the joy of spending them, but if you are investing for a long-term goal such as retirement you need to plough them back into your portfolio.

Sam Instone, the managing director of advisers AES International in the UAE, says dividends continue to boost the value of your investments even if the wider stock market stagnates or dips, but only if you constantly reinvest them rather than strip them out and spend them.

This even makes stock-market volatility work in your favour, because when shares dip your reinvested dividends pick up more stock at the lower price. “Dividends can keep the value of your investments rising even if market performance slips.”

Another benefit is that most companies aim to increase their dividends year after year, giving you a rising income stream as well. “The positive effect is amplified over time, helping you generate a superior return over the long-term,” Mr Instone says, adding that you after you retire, dividends then do another valuable job. “At that point you can start drawing them as income to top up your pension.”

Investing in individual company shares is too risky for many, but you can still benefit from dividend investing through a mutual fund or ETF, with many allowing you to draw income on a monthly basis, Mr Instone says.

He recommends using ETF manager Vanguard’s low-cost LifeStrategy fund range to build a simple, balanced portfolio. “You can shift between ‘accumulation’ units, where your dividends are invested for long-term capital growth, and or ‘income’ units, where you take the income.”

Steven Downey, an associate at Holborn Assets, says every investor should take into account the total return from both share price growth and dividends when planning their portfolios. “Too many focus on one while ignoring the other.”

He urges caution before investing in stocks with super-high yields of, say, 6 per cent or more.

The yield is calculated by dividing the dividend by the share price. So if a stock trades at $100 and the dividend is $4, the yield is 4 per cent. However, if the share price plunges to $50 following a shock profit warning, that $4 suddenly works out as a yield of 8 per cent. That looks attractive, but you are investing in a company in trouble.

“Do not just look at the dividend, as this will not give you the full picture of a company’s health.”

Plenty of low-cost ETFs allow you to invest in dividend stocks. Mr Downey says US citizens might consider Cambria Shareholder Yield, which trades under the ticker, or stock market code, SYLD. “It invests in US companies that pay a large amount of their earnings back to shareholders through dividends and share repurchases, with total annual charges of 0.59 per cent.”

Mr Downey tips another US-domiciled fund, the Dow Jones EPAC Select Dividend Index (IDV), which invests in high-quality dividend stocks, and charges just 0.5 per cent.

However, Mr Downey says expats from other countries should avoid US-domiciled funds for tax reasons, and tips two alternative ETFs that offer high yields from bonds and property.

The iShares Global High Yield Corporate Bond UCITS ETF (HYLD.LN) invests in corporate bonds issued by companies that have slightly higher levels of risk but pay more income as a result. It yields 4.7 per cent and charges 0.5 per cent.

The SPDR Dow Jones Global Real Estate UCITS ETF (GLRE. LN) invests in property companies and yields 3.6 per cent with charges of 0.4 per cent. “All these funds offer far higher yields than you can get on cash today,” Mr Downey says.

Oliver Smith, a portfolio manager at online platform IG Index, tips a number of global ETFs that target companies paying attractive dividend income and are suitable for non-US residents.

He names SPDR S&P US Dividend Aristocrats (USDV), Vanguard FTSE All-Share High Dividend (VHYL), db x-trackers EURO STOXX Select Dividend (XD3E), and iShares Asia Pacific Dividend (IAPD).

“These are not necessarily the highest yielding in the market but they also offer a good degree of diversification,” Mr Smith says.

As record low interest rates inflict yet more damage on savers, now may be time to add to some unsung heroes to your portfolio.