By David Brett – Investment Writer – Schroders
‘Compounding’ can have a dramatic effect on returns. We highlight the difference it has made for major stock markets.
Reinvesting dividends is one of the most powerful tools available for boosting returns over time. Investors in the MSCI World would certainly have noticed the difference over the last 25 years.
For instance, if you had invested $1,000 on 01 January 1993 in the MSCI World, the capital growth would have produced a notional return of $3,231 (by 7 March 2018). Annually, that represents a growth rate of 5.9%.
But the picture changes again once dividends, the regular payments made by companies to their shareholders, and the miracle effects of “compounding” are included.
By reinvesting all dividends, the same $1,000 investment in the MSCI World would have produced a notional return of $6,416, representing annualised growth of 8.3%.
In percentage terms, it’s the difference between your money growing by 323%, without dividends reinvested, or 640% with dividends reinvested, nearly twice as much.
The reason for this stark difference in returns is the compounding effect, where you earn returns on your returns. This can snowball over time to produce far more than you might expect.
The same story has been repeated across many stockmarkets in the past 25 years.
As the table below shows, if you invested in the FTSE 100 you could have almost doubled your returns by reinvesting dividends. In China reinvesting dividends might have been the difference between making a profit and a loss.
Each index would have returned more if you reinvested dividends.
Overall, the average annual growth across eight markets without dividend reinvestment was 4.3%. Including dividend reinvestment increased the average to 7.1%.
However, returns have fluctuated for each index year-on-year in much the same way as the MSCI World Index illustrated in the chart above. Stockmarket investing carries a high degree of risk and past performance is no guide to future performance and may not be repeated.
| Index | Annual return excluding dividends | Annual return including dividend reinvestment |
|---|---|---|
| Hang Seng (Hong Kong) | 7.0% | 10.7% |
| S&P 500 (US) | 7.5% | 9.7% |
| MSCI World | 5.9% | 8.3% |
| MSCI Emerging Markets | 5.3% | 8.0% |
| FTSE 100 (UK) | 4.1% | 7.8% |
| CAC 40 (France) | 4.3% | 7.6% |
| MSCI Japan | 1.3% | 2.8% |
| MSCI China | -0.5% | 2.0% |
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 correct as at 07 March 2018. Returns based on local currency.
Low interest rates, part of the measures deployed by central banks to revive flagging Western economies following the global financial crisis, have driven down yields on more traditional sources of income such as government bonds (gilts) and savings accounts.
Interest rates, and government bond yields, across much of the developed world remain near historic lows.
For example, yields on 10-year benchmark government debt in the UK, Germany, and Japan are 1.54%, 0.67% and 0.03% respectively, according to Thomson Reuters data. The yield on US government debt is a little higher at 2.88%.
But compare that with 25 years ago, the starting point of our dividend data, and it’s starkly different: all four bonds were yielding more than 4.5% in 1993.
By comparison, the dividend yield on the FTSE 100 is now 4.1%. In the US it is 3% and in Japan it is 2%. This is why income-hungry investors have turned their attention to stockmarket dividends.
The chart below shows global government bond returns over the last 25 years.
If you had invested $1,000 on 01 January 1993 in government bonds, as measured by the BofAML Global Government Total Return Index (including interest payments), the capital growth would have produced a notional return of $2,548 (by 7 March 2018). Annually, that represents a growth rate of 5.1%.
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.
When purchasing a share, investors can elect how they will receive any future dividends. They can choose to receive cash, referred to as income, or use that money to repurchase more company shares.
Investors must elect to repurchase more shares to trigger the start of a process Albert Einstein called “the eighth wonder of the world”: the miracle effect of compounding.
Compound interest, put simply, is interest on interest and it can help an investment grow at a faster rate. By reinvesting dividends, you give your stock holding the potential to earn even more dividends in the future.
Of course, the value of compounding increases over time, accelerating shareholder value, especially when share prices increase.
It is important to remember companies do not have to pay dividends and dividends can be cut or cancelled at any time.
Some companies even borrow money to pay dividends, to keep investors happy. This is not always a sustainable approach.
Borrowing money to pay a dividend could be a symptom of a company with a weak balance sheet. It is advised that investors do their due diligence before they make any investment.
Nick Kirrage, Fund Manager, Equity Value, said:
“Dividend reinvestment is one of the most powerful investment tools available. As our research shows, the potential difference to the rate of return dividend reinvestment makes could be substantial.
“In an era where interest rates are so low investors need to be aware of relatively simple investment techniques that can help them build up their returns. Dividend reinvestment is a simple technique.
“Over time, those seemingly small amounts reinvested can grow into much bigger sums if you use them to buy even more shares that pay dividends in turn.
“Investors need to do their research and make sure the company they are investing in can afford to pay their dividends on a sustainable basis. Your original capital is also at risk, so it pays to be picky.
“As a way of building up your investments dividend reinvestment can be powerful.”