Reinvesting dividends can be a powerful way to boost your long-term returns from the stock market.
When you invest in shares, there are essentially two ways in which you can earn a return. One, the share price goes up – capital growth. And two, dividend payments – income.
For many investors, the dividend payments they receive are an important part of their overall income which they use to support their general spending.
However, for people who don’t need an income from their shareholdings – or don’t need it yet – reinvesting these dividends can dramatically increase their long-term investment return.
The chart below shows the huge difference that reinvestment can make. Suppose you had invested £5,000 in the FTSE 100 index of leading UK shares back in 1985. That £5,000 would have grown to £27,211 by 2017.
However, if you had reinvested the dividend payments in to the FTSE 100, your original £5,000 would have grown to £91,458 – more than three times as much.
With the former, your investment would have grown 444 percent. Not to be sniffed at - plus you’ve been able to spend the dividend income every year.
However, by reinvested the dividends, your investment would have grown 1,729 percent overall.
The long-term rewards from reinvesting dividends can be very significant.
Reinvestment is certainly worth considering if investors don’t need their dividend income at the moment – and it’s straightforward to do with many investment funds.
Compounding: “the most powerful force in the universe”
This substantial difference in investment returns shows the benefit of what is called compounding.
Think of compounding as a snowballing in the value of your investment, as your reinvested dividends buy more shares which pay more dividends which buy more shares – and so on.
As the chart highlights, its benefit can be particularly impressive over the long term.
No less a figure than Albert Einstein reportedly even called compounding “the eighth wonder of the world” and “the most powerful force in the universe”.
Investors can harness the power of compounding by, for example, starting to save for their pension at an earlier age rather than leaving it until later in life.
This can help them accumulate a bigger pension pot than someone who starts saving later. Or by investing on behalf of a child from a young age, perhaps through a Junior Isa, so that when the child reaches adulthood they have a sizeable sum of money to use for university costs or even as a deposit to buy their first property.