The power of reinvesting dividends

Juliet Schooling Latter 17/05/2023 in Equities, Income investing

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

This article is provided for information only. The views of the author and any people quoted are their own and do not constitute financial advice. The content is not intended to be a personal recommendation to buy or sell any fund or trust, or to adopt a particular investment strategy. However, the knowledge that professional analysts have analysed a fund or trust in depth before assigning them a rating can be a valuable additional filter for anyone looking to make their own decisions.Past performance is not a reliable guide to future returns. Market and exchange-rate movements may cause the value of investments to go down as well as up. Yields will fluctuate and so income from investments is variable and not guaranteed. You may not get back the amount originally invested. Tax treatment depends of your individual circumstances and may be subject to change in the future. If you are unsure about the suitability of any investment you should seek professional advice.Whilst FundCalibre provides product information, guidance and fund research we cannot know which of these products or funds, if any, are suitable for your particular circumstances and must leave that judgement to you. Before you make any investment decision, make sure you’re comfortable and fully understand the risks. Further information can be found on Elite Rated funds by simply clicking on the name highlighted in the article.