Is this the best investment tip of them all?
So, you’ve made your decision. You’ve decided how much risk you're happy to accept and researched your investment options. You are set to take the plunge and invest some of your hard-earned cash.
Before going any further, there’s one concept that I’d like to share: the reinvestment of dividends.
Now it may sound a little dry, but it has the potential to make an extraordinary difference to the money you might make.
It certainly has made a difference to returns in recent decades. If you’d invested £1,000 into the UK stock market in the year 2000, the growth of your investment would make it worth £1,016 today. You would have also been paid some income – the dividends. Now if you’d reinvested those dividends to invest more into the stock market, the investment would be worth £1,920.
I’ll explain more on the maths behind this shortly but first a quick word on the basics of how dividends work.
A dividend is a sum of money paid regularly (typically twice a year) by a company to its shareholders out of its profits.
When you make an investment in the stock market it could be buying shares directly through a broker or it could be through a fund, where a fund manager chooses a basket of shares for you.
With shares, you could instruct your broker to reinvest the dividends each time they’re paid. They’ll probably charge you a small amount for this. With funds you can normally choose one of two types - “income” (cash) or “accumulation” (repurchasing). It often has “inc” or “acc” in brackets after the fund name. “Income” pays out, “accumulation” buys you more of the fund.
Before I talk you through the calculations, it’s worth mentioning that companies don’t have to pay a dividend, and they can reduce or cancel them at anytime. You could possibly lose some or all of your original investment as well.
Here’s the science bit. The proof that dividend reinvestment could make a big difference to your returns.
We have used the FTSE 100, an index for the biggest 100 companies listed on the UK stock market, as our guinea pig.
Let’s say you (or your parents) had invested £1,000 in the FTSE 100 on 31 December 1999 – the stock market was surging higher, it seemed like a sure bet. Now as it turned out, that was a peak for the stock market and the years that followed were pretty dire.
In fact, the last 18 years have seen many ups (a boom up to 2007 driven by credit and fast-growing emerging markets) and downs (the grim financial crisis of 2008).
Today that £1,000 investment would be theoretically worth just £1,016. That represents a notional return of £16 or a pitiful annual growth rate of just 0.09% (based on figures taken on 20 March 2018).
Now add dividend reinvestment into the mix.
By reinvesting all dividends, the same £1,000 investment in the FTSE 100 would be worth £1,920. That’s a notional return of £920 or an annual growth rate of 3.9%.
In total percentage terms, it’s the difference between your money growing by 20%, without dividends reinvested, or 91.9% with dividends reinvested.
As the chart below shows, the difference in returns get bigger the longer you’re invested. That’s because of the miracle effects of compounding.
It’s about sacrificing some cash today – the income – for more cash tomorrow, assuming all goes to plan. If you can think of a better investment tip, I’d love to hear it.
Chart title: FTSE 100 returns with vs without dividends -1999-2018
Please remember past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.
Source: Schroders. Thomson Reuters data for the FTSE 100 and the FTSE 100 Total Return (including dividends) correct as at 20 March 2018.
So, while it is tempting to take the cash and go out and celebrate, if you can afford it and have time to let the investment grow reinvesting dividends could be something to seriously consider.