The Impact of Reinvesting Dividends

Markets are volatile; they go up and down. Volatility and falling market returns are often seen as a negative, and understandably so, however these things are not inherently bad and in fact present investors with an opportunity for even greater growth.

If we look at the market over the past 30 years (below) we see that periods of volatility and negative returns have traditionally always been followed by strong market recovery, therefore offering an opportunity to take advantage of the old adage, “buy low, sell high”.

FTSE100 market returns since 1989. Source: FE Analytics 03/06/2019

The problem, of course, comes with predicting when “the low point”, is, in fact, the low point. For anyone familiar with the cycle of market emotions, you’ll be aware that human psychology means that without the proper guidance and advice, as human beings, we are at risk of acting completely counter-intuitively and buying high, selling low.

Cycle of Market Emotions: We are most at risk of buying in the red zone and selling in the green, when we should be doing the exact opposite!

Cycle of Market Emotions

I’m sure everyone knows the feeling. Markets are rising, everyone seems to be achieving growth on their investments and you don’t want to miss out, so you decide to invest. Perhaps (using the terminology on the graphic above) you get into the market at the point of “thrill”, or even “excitement”. Everything seems to be going great… and then markets start to move against you. You witness your investment falling in value. You start to think that perhaps this wasn’t a good idea after all, and as markets continue to fall, you decide to get out.

The first thing that needs to be acknowledged is that investing in the market is a long-term growth strategy, and with any investment there are going to be periods of negative returns, and higher volatility. There’s another old adage which we like, which states that it’s “time in the market, not timing the market”. No one has a crystal ball, and we do not know when markets will go up and down, but we do know that there are growth opportunities at every stage of the cycle.

So, we know that the ideal plan is to “buy low” i.e. invest more when markets are falling, but not everyone has cash sitting in the bank, ready to invest when markets start to turn. Thankfully, investments will actually take care of this themselves if you allow them to. Let us explain.

Companies issue something called “dividends”, on a semi-regular basis. Dividends are a share of the company’s net profit, and if you hold stock in the company then you are entitled to a dividend when one is issued.

How does this help? By their very nature dividends are issued by a company on the basis of the profit they generate; not their share price. So, if a company achieves a net profit and issues dividends of £1 per share, you receive £1 per share you hold, irrespective of whether the share price is £10 or £100.

You then have the option of receiving this dividend as a cash payment or reinvesting this dividend to buy more shares in the company. This is where the real magic happens. If you choose to reinvest the dividend in the company, then the company is effectively providing you with that cash lump sum to invest in the falling markets we discussed earlier. Even better, companies issue dividends at different times of the year, so if you hold a varied portfolio of shares, you will be receiving dividends and reinvesting these at all different times in the market cycle, without thinking about it, helping compound the growth of your portfolio in a rising market.

We’ve looked at the impact of reinvesting dividends in different market conditions below:

Scenario 1: Medium Investment Growth

  • •   In this scenario, “Company X” has profit of £1,000 and total shares of 1,000 – therefore profit per share is £1
  • •   The investor in “Company X” has 10 shares, therefore they receive dividends of £10 (£1 profit per share x 10 shares)
  • •   The share price is £1 per share and therefore the value of the shares is £10 (£1 x 10 shares)
  • •   As the investor is reinvesting dividends the dividend is used to purchase shares at a share price of £1
  • •   As the dividend received was £10, this buys an additional 10 shares (£10 divided by a share price of £1)
  • •   The investor then has 20 shares which can hopefully grow in value as the share price grows

Scenario 1

Scenario 2: Negative Growth

  • •   In this scenario, company profit remains the same as scenario 1
  • •   The investor still has the same number of shares and therefore still receives the same level of dividend (£10)
  • •   The share price is lower than scenario 1 at £0.50 per share and therefore the value of the shares is £5 (£0.50 x 10 shares)
  • •   As the investor is reinvesting dividends the dividend is used to purchase shares at a share price of £0.50
  • •   As the dividend received was £10, this buys an additional 20 shares (£10 divided by a share price of £0.50)
  • •   The investor then has 30 shares which can hopefully grow in value as the share price grows

Scenario 3: Positive Growth

  • •   In this scenario, company profit remains the same as scenario 1
  • •   The investor still has the same number of shares and therefore still receives the same level of dividend (£10)
  • •   The share price is higher than scenario 1 at £2.00 per share and therefore the value of the shares is £20 (£2.00 x 10 shares)
  • •   As the investor is reinvesting dividends the dividend is used to purchase shares at a share price of £2.00
  • •   As the dividend received was £10, this buys an additional 5 shares (£10 divided by a share price of £2.00)
  • •   The investor then has 15 shares which can hopefully grow in value as the share price grows

Scenario 3

So, by reinvesting your dividends you are buying more shares all throughout the market cycle, and negative returns actually result in you holding more shares which can grow in rising markets. This can have a massive impact on investment returns over the long term. Below we’ve compared the FTSE 100 returns over the past 10 years with and without reinvesting dividends:

Accumulation Index

Source: FE Analytics 03/06/2019

Without reinvesting dividends, the FTSE 100 has returned 62.11% over the past 10 years. By reinvesting dividends these returns are more than doubled to 136.46%. This is an exceptional increase in the total portfolio return, and to be clear, the dividends paid in each situation are exactly the same, the only difference is reinvestment and therefore compounding of returns.

So, it’s not all doom and gloom when markets are falling. In fact, an educated investor with good advice, wishing to invest over the long term could actually argue the opposite. Albert Einstein is said to have described compound interest as the eighth wonder of the world, and “the most powerful force in the universe”, certainly from a financial standpoint we believe he was onto something.

Again, we would always stress that investing in the market is a long-term growth strategy. Investing purely in the UK stock market is a very high-risk strategy and it is important that you seek proper financial advice to ensure that you hold a diversified portfolio akin to your risk tolerance.

If you would like to talk to us about how dividend reinvestment might work for you, please feel free to get in touch on 0207 713 9356.