Reinvesting dividends : it doesn't take a genius
We do not know how he fared as a stock-picker, but Albert Einstein encapsulated a vital principle of investment when he described compound interest as ‘the most powerful force in the universe’. Leaving aside whether the great physicist actually said that, compounding is one reason why reinvesting dividend payments can have a dramatic impact on total returns over the longer term.
How dramatic? The chart below compares the actual price of UK equities with the total returns available through dividend reinvestment over the longer term. Even over a 20-year time frame, the divergence is considerable. Excluding charges, £100,000 invested in 1997 would be worth around £187,500 today if dividends were not reinvested. With reinvestment, the same sum would be worth around £360,000, nearly twice as much.
While there are no guarantees that this relative performance would be repeated, there are two main underlying reasons why reinvesting dividends helps to produce such attractive long term returns. One is behavioural. A strategy, or habit, of investing income accrued encourages investing in falling markets and disregards short term turbulence. Default reinvestment minimises the potential damage of market ‘noise’ on real time investment decisions. It is, after all, mainly hindsight that shows the sense of investing during the lows of 2003 and 2009. Not many would actively choose to invest fresh funds amid concerns over the global economy, such as occurred in 2009. A strategy of regularly investing accruing income assumes that good investment decisions are more likely to be made by default, as few of us choose to defy all-pervading market opinion.
While Speirs & Jeffrey does not offer a stock-specific dividend reinvestment programme, our practice is to allow income to build up until it reaches a reasonable value, at which point we reinvest the funds. The other reason for the success of a reinvestment strategy is mathematical - the long term effect of compounding said to have impressed Einstein.
Gradually building up a portfolio means that it should produce higher levels of income, which will produce further funds for reinvestment, snowballing over time. The longer the time horizon, the more marked the effect. According to Barclay’s 2016 Equity Gilt Study, the same £100 invested in equities in 1945 would be worth £8,919 without reinvesting dividends and £181,676 with dividends reinvested.
Whilst a 72-year time horizon is too long for any individual investor to benefit from, that multiple of 20 between the first and second figures shows the power of reinvesting dividends. Again, this past performance might never be repeated, but it suggests there is great value in harnessing that power for as long as possible.
1 March 2017