The power of compounding

Most investors know a few of the basic rules. Buy low, sell high. Don’t put all your eggs in one basket. Don’t try to guess the market or take on more risk than you can afford. But far fewer people know about the “magic” of compounding – and how your returns can grow exponentially.

In basic terms, compounding means that by drip-feeding smaller amounts of money into your investments consistently over time, and leaving them there to grow, your return may well be higher over the long term than if you just invest one lump sum and hope that it will rise.

Reinvesting dividends is the best-kept secret in the investment world to make sure you benefit from compounding. Dividends are an amount of money paid out – usually once or twice a year – to shareholders that have a stake in a company; investors receive a coupon if they own a bond. While some investors treat that money as regular income, others decide to reinvest it by buying more of the same stock or bond.

Let’s look at how compounding could work in your favour. If you had invested £1,000 in a fund that tracks all the companies in the UK’s FTSE All-Share Index on 31 August, 1998 and taken the dividends as income, your investment would be worth £1,682.30 by 31 August, 2018. However, if you had reinvested the dividends, that same £1,000 would now be worth £3,268.10 – almost double over the same timeframe¹.

Why such a difference? Because you’re making a return not only on the lump sum you first invested, but also on the dividends which you put back into your investment, making your money work that much harder.

A good way to track what you can expect from your investment is by looking at the dividend yield of a stock, bond or market. For example, the FTSE All-Share Index’s current dividend yield is 3.78 per cent² – which means if you invest £100, you should expect a dividend worth 3.78 per cent of your investment. The yield, however, can go up and down. A dividend yield can be used to assess whether a company is in good health – although company boards can decide to cut their dividend payouts as and when they need to. (Bond coupons are guaranteed, unless the bond issuer goes bust.)

Here’s a simple example. You invest £100 into a stock and get a dividend of £3. The stock goes up by 5 per cent over one year. So, adding in the dividend, your investment is now worth £108. The same happens the next year – your £108 goes up by 5 per cent to £113.40, and with another £3 dividend reaches £116.40. If you hadn’t reinvested those dividends, your £100 investment would only have been worth £110.25.

It might not sound like a big difference over two years, but over five to 10 years or an even longer timeframe, those returns really add up. That’s why, to benefit from compounding, you should stay invested for as long as possible.

But no matter how long you stay invested, there are no guarantees you will make back the money you first put in. All markets go up and down, and if the winds are blowing against you, compounding will not work in the same way. In fact, reinvesting dividends at this point will only put more money into a losing stock. That doesn’t mean you should change your strategy just because the market is going down. Generally speaking, even if the market dips, investing small amounts – for example, monthly via direct debit into your ISA – is always a preferable strategy to saving up and investing a large lump sum. It smooths out the peaks and troughs of the market and makes sure a large dip in your chosen stock’s fortune won’t put you off from investing overall.

If you decide to place your cash in a diversified and professionally managed fund – whether it’s actively managed, with a fund manager picking securities, or a passive fund that tracks an index such as the FTSE 100 – make sure you choose the right share class for you. “Acc” stands for accumulating and means it accumulates all dividends and reinvests them in the fund for you. “Inc” stands for income, and dividends will be paid to your bank account probably on an annual or semi-annual basis, although some funds pay as often as monthly.

(If you trade individual stocks and bonds, you can set up a plan via your broker or trading platform to reinvest dividends or take an income.)

And, of course, if you need the income, there is nothing wrong with taking your dividends out of the fund. It all depends on your time horizon, how much risk you can take and what income you need. A financial adviser might be able to help you make the right choice.

¹Source: Morningstar, September 2018
²Source: FTSE Russell, FTSE All Share Indexes, 31 August 2018