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Reinvesting dividends over the long term can make a huge difference to your portfolio
Thursday 16 Nov 2017 Author: Emily Perryman

Compounding was once described by Albert Einstein as the eighth wonder of the world because of the seemingly magical way it can super-charge investment growth. We’ve compiled some figures and tables to show you how it works in practice.

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What is compounding?

Compounding describes the process where investment returns themselves generate future gains. The value of an investment can increase exponentially because growth is earned on both the initial
sum of money plus the accumulated wealth.

Imagine you invest £1,000 in a stock and it increases by 5% in year one to £1,050. If the stock rises by another 5% in year two, it will be worth £1,102.50. In the first year you earned £50 and in the second year you earned £52.50.

The effect of compounding over the long-term

The impact of compounding becomes very powerful if you invest for a long time. In fact, it takes around a decade for the effects to be really noticeable. It is perhaps why legendary American investor Warren Buffett once asserted: ‘If you don’t feel comfortable owning a stock for 10 years, you shouldn’t own it for 10 minutes.’

To truly harness the power of compounding you need to start investing early. If you invested £200 a month from age 20 until age 65 you could end up with a pot more than three times
bigger than someone who started at age 40 saving  the same amount  each month.

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These figures assume an annual growth rate of 5% after charges.

Even if you invest a greater amount each month in your
later life, you won’t benefit from the same growth as someone who started investing a smaller amount earlier.

For example, a 25 year-old who invests £100 a month will have a total fund value at age 65 that is almost double that of a 45 year-old who starts putting aside £200 a month. This is despite the total amount invested being the same.

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These figures also assume an annual growth rate of 5% after charges.

Why reinvesting dividends reaps rewards

You can make compounding work even harder for you by reinvesting dividends – as that means you own more shares. You then receive more dividends next time, which you reinvest to get more shares, and so on.

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‘The cycle becomes a virtuous one, providing the dividend payments are maintained or, better, still keep growing. The strategy breaks down if dividends are reduced or – in a worst case – cut altogether if a firm gets into trouble of some kind,’ explains Russ Mould, investment director at AJ Bell Youinvest.

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By looking at the compound annual returns from the FTSE 100, you can really notice the difference that harvesting and reinvesting dividends makes.

To turn this into hard numbers, a £4,000 investment in the FTSE 100 in 1987 with dividends banked rather than reinvested would now be worth around £32,000 (excluding fees).

With dividend reinvestment, it would be worth more than £59,000 (excluding fees) had it matched the total return from the index. That clearly illustrates compounding benefits.

How to exploit compounding

When it comes to building an investment portfolio there are two main ways to harness the power of compounding: pick the individual stocks yourself or choose a fund where the fund manager does it for you.

Mould says if you’re looking for individual stocks that will be reliable long-term dividend compounders, you must carry out thorough checks to ensure the company’s competitive position is strong enough and the finances are in order.

Issues to consider include the company’s competition, how easy is it for customers to defect, pricing power, how sound are the finances and management competence. The latter two in particular will have a bearing on the likelihood of the company being able to maintain or increase dividends, regardless of the broader economic and stock market conditions.

‘If this all sounds like hard work, that’s where a good fund can help,’ says Mould. ‘There is a plentiful selection of so-called income funds which target stocks capable of paying healthy and sustainable yields in the UK or farther afield.’

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How to choose funds

When choosing a fund in order to exploit the powers of compounding, the key is to buy the accumulation units. They will have ‘acc’ somewhere in their name, highlighting the fact they will effectively reinvest dividends for you. Income (or ‘inc’) units will pay out dividends as cash at regular intervals.

If you want an actively-managed fund, Mould suggests considering Newton Global Income (GB00B7S9KM94), the UK-focused CF Woodford Equity Income (GB00BLRZQ737) and JP Morgan Emerging Markets Income (GB00B5T0GN09).

Passive funds dedicated to income are rarer, but one which automatically reinvest dividends is SPDR FTSE UK
All-Share UCITS ETF (FTAL)
. The yield on the underlying index, the FTSE All-Share, is around 3.8%. (EP)

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