The power of reinvesting dividends

Compound interest is possibly the most important concept people can learn about when it comes to their finances. It’s so important that Albert Einstein once described it as the eighth wonder of the world. “He who understands it, earns it… he who doesn’t, pays it.”

Most readers are probably familiar with the concept – it’s interest on interest. But not everyone recognises its true power. When it comes to debt, it can make it worse. When it comes to investments, it can boost them.

When debt gets out of control

Let’s take the example of credit card debt at £1,000 with an interest rate of 20% per annum. If this is calculated monthly, even if you pay the minimum amount back each month, because you start paying interest on your interest, your debt will double in just four years*.

On the flip side, investments that generate an income can work even harder for you. By using the income to buy more shares, bonds or units, your pot grows bigger, and you earn interest on that interest again.

The value of reinvesting dividends from shares is shown very clearly when you look at the FTSE All Share index.

Over the past five years, the index is almost flat. On 21 September 2018 it was at 4,128 points**. On 20 September 2023 it was at 4,193 points**. That’s a gain of just over 1%. However, if you had reinvested the dividends earned from its companies in that time, your total return would have been just over 22%***.

This relationship holds true over all time periods as you can see in the chart below:

Why dividends are even more important today

A number of fund managers we have spoken to recently believe that dividends will play an even greater role in the current environment. They say this is because historically, during periods of low growth, they make up a more significant part of total returns. During periods of high inflation, stocks with high dividend yields have also tended to outperform.

UK equity income funds

Investors wanting to take advantage of dividends could consider investing in a UK equity income fund. These funds specifically target dividend paying companies.

GAM UK Equity Income, for example, invests in companies of all sizes – from the very small and those listed on the AIM stock market, through to those that are found in the FTSE 100. While the manager is targeting a yield higher than that given by the UK stock market, he is also looking for steady dividend growth. He can also invest some money in a company’s bond if he feels the opportunity is better.

IFSL Marlborough Multi Cap Income is another option. This fund has a bias towards smaller companies and aims to combine fast and sustainable dividend growth with capital appreciation. The portfolio is constructed primarily by picking individual companies on their own merit, but economic drivers can also influence decisions. The fund uses a blend of ‘value’ and ‘growth’ holdings to meet its yield objective.

Investors wanting the reassurance of a growing dividend could consider The City of London Investment Trust. Launched in 1891, it is one of the longest-running investment trusts in the UK and aims to provide growth in income and capital by investing predominantly in larger UK companies with international exposure. It has increased its dividend payment every year for the past 56 years.

Research all Elite Rated UK equity income funds here.

*Source: Google Finance

**Source: FE fundinfo, price and total returns in sterling, to 19 September 2023

This article was updated on 20 September, 2023

_{Photo by Steve Harvey on Unsplash}