When it comes to building long-term wealth from the stock market, dividend reinvestment is one of the most powerful tools in an investor’s arsenal.
Not convinced? Consider the example below.
Growth of a £10,000 portfolio
Analysts at Hargreaves Lansdown recently examined the growth of a £10,000 portfolio invested in the FTSE 100 for 30 years between 31/08/1987 and 31/08/2017.
With NO reinvestment of dividends, the £10,000 portfolio grew to £35,500 after the 30-year investment time horizon. That’s a gain of around 255% or an annualised return of 4.3%.
However, that same £10,000 invested for 30 years, WITH the reinvestment of dividends grew to a staggering £106,000. That’s a total return of 960%, or an annualised return of 8.2%, a significantly higher figure.
Source: Hargreaves Lansdown, Lipper
That is no doubt a considerable difference. Why did the portfolio with reinvested dividends perform so much better? One word – compounding.
The incredible wealth building power of compounding
Compounding is the process of generating earnings on an asset’s previous reinvested earnings. It’s a concept that most of us learn at high school, yet in the real world, it’s often overlooked.
The power of compounding is an extremely important concept to grasp in relation to wealth building, because over time, it can result in the exponential growth of an investor’s capital. The chart below shows how £10,000 grows with 5% compound interest (interest is reinvested) vs 5% simple interest (interest not reinvested). Note the exponential curve of the blue bars.
Source: Dividend Wealth
Ask investing legend Warren Buffett about the importance of compounding, and he’ll explain that it’s one of the largest factors behind his success as an investor.
And that’s where dividends play a key role, because dividends and compounding go hand in hand. A dividend investor has the ability to compound on a regular basis, simply by reinvesting his or her dividends to buy more shares. The results, over the long term, can be powerful.
This article is provided for general information only and is not intended to be investment advice. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.