Dividends are often associated with providing an income, but they can also be invaluable when it comes to growing your money over the long term.
Our research shows that, over the last decade, investors who reinvested dividends could have achieved a far greater return than those who took dividend income as cash.
Read on to find out why reinvesting dividends is so powerful, the difference between price return and total return, and the potential pitfalls to be aware of.
The power of reinvesting dividends
Reinvesting dividends – where you buy additional shares with your dividends rather than taking the cash – can be a very effective way of boosting investment returns over long periods.
Reinvesting dividends lets you harness the power of compound returns – in simple terms, that means getting returns on returns. You receive a dividend, which you use to buy more shares, which pay more dividends, which in turn buy more shares, and so on.
Let’s imagine you buy £1,000 worth of shares in a company paying a 3% annual dividend yield and reinvest your dividends every year for a decade. In year one, you’d earn £30 (3% of £1,000) and your investment would grow to £1,030. The following year you’d earn £30.90 (3% of £1,030), increasing your investment to £1,060.90. After ten years, your original investment could be worth £1,343.92 – and that’s before any increases in the share price.
If the share price also rises, this would have an even greater impact on your investment because you’d benefit from both capital growth and dividend growth. And even if the share price temporarily declines, reinvesting dividends would enable you to buy shares at a lower price and then hopefully reap rewards as the share price recovers.
Price return versus total return
One way to illustrate the way in which reinvesting dividends has helped to supercharge investment returns in the past is to compare an equity index’s price return with its total return. Price return measures changes in share prices only, whereas total return measures changes in share prices plus dividends or any other cash distributions. Total return also assumes dividends are reinvested.
The chart below shows the impact of investing £1,000 in the FTSE All Share between 1 January 2012 and 28 September 2022. Based on share price changes alone, that £1,000 investment would have produced a notional return of £1,337 before fees. When dividends are included, the return rises to £1,969 before fees – that’s 47% higher.
Source: RBC Brewin Dolphin / Refinitiv Datastream
Neither simulated nor actual past performance are reliable indicators of future performance. Performance is quoted before charges which will reduce illustrated performance.
Pitfalls to watch out for
Although reinvesting dividends can be a powerful way of growing your money over the long term, this doesn’t mean you should base your investment decisions solely on a company’s dividend yield.
Dividend yield is calculated by dividing the dividend per share by the price per share, so the yield could rise simply because the share price is falling – that could indicate the company is in distress and could be a potential ‘value trap’. It’s really important that you invest in companies with strong fundamentals and which are expected to generate consistent returns over time. This can be complicated and is generally best left to the experts.
It’s also worth bearing in mind that dividends are not guaranteed. There have been several instances throughout history when companies have been forced to cut dividends. For example, over the 12 months to March 2021, UK dividends declined by 41.6% as two-thirds of companies reduced or pulled their dividends during the pandemic1.
This is another reason why it’s important to look at the bigger picture, and accept that fluctuations in share prices and dividends are par for the course when it comes to growing your money over the long term.
Understanding where and how to invest your money isn’t always easy – and that’s where getting some smart advice can help. By getting to know you and what you want to achieve, a financial adviser can build a portfolio that suits your individual circumstances and works hard to grow your investments over the long term.
The value of investments, and any income from them, can fall and you may get back less than you invested. Neither simulated nor actual past performance are reliable indicators of future performance. Performance is quoted before charges which will reduce illustrated performance. Investment values may increase or decrease as a result of currency fluctuations. Information is provided only as an example and is not a recommendation to pursue a particular strategy. Information contained in this document is believed to be reliable and accurate, but without further investigation cannot be warranted as to accuracy or completeness.