Dividend Reinvestment is a must to Maximise Wealth Building

There are almost as many investment strategies as there are financial websites.  These might include everything from you must buy this share as it’s a guaranteed ten bagger through to a fund that looks like it will protect you no matter the economic weather.  Of course the strategies discussed will also likely be dependent on whether the person writing the strategy has a vested interest of some description.

I’ve laid out my strategy for all to see however it glossed over an exceptionally important element.  That element is share dividends and specifically how crucial it is to reinvest them while you are building your portfolio.  If you are a UK Investor Monevator touched on this topic back when I was first starting on my Retirement Investing Today journey and more recently DIY Investor has also reinforced their importance but it’s the must have Investing Bible for UK Investors that really reinforces the point with the section entitled “Spend dividends at your peril”.  Dividend reinvestment is important because it is likely they make up a significant proportion of the total return that comes from your individual share holdings, High Yield Portfolio (HYP) or Index Tracking Fund to name but three.  By reinvesting you both get that extra cash into your portfolio, instead of being tempted to buy something you likely don’t really need, but additionally you also then get those dividends compounding year on year.

Let’s look at whether reinvesting dividends is still important in more recent times using my recently built FTSE100, FTSE250, FTSE Small Cap and FTSE All Share data sets.  For today’s analysis I am using the period 18 March 2008 (the first date I was able to source all data required) to the recent market close of the 28 March 2013.  The annualised return or compound annual growth rate (CAGR) for capital growth only and dividend reinvestment for these four datasets is shown below.

Click to enlarge   

This shows that depending on the index the contribution of dividends to total annual index return is anywhere between 30% and 60%.  This shows the importance of dividend reinvestment but it doesn’t tell the whole story because is doesn’t take into account one other important consideration.  These indices are measured in £’s and we all know that the value of the £ is continually being devalued by inflation.  By correcting for this the table then becomes.

Click to enlarge  

This then really rams home the importance of dividend reinvesting with between 43% and all of the real annualise return coming from dividends.  So what does this mean for the average investor?  Let’s run some simulations over the same period.

Average Bob and Average Joe both invest £100 in a low cost FTSE100 Index Tracker on the 18 March 2008.  The difference is that Bob spends his dividends where Joe reinvests his.  Today in Real terms Bob has gone backwards with his fund now only worth £96.57.  Joe on the other hand has a fund worth £116.82.  This is shown in the chart below.

Click to enlarge 

Running the same analysis for the FTSE250 we find Bob with a fund worth £122.44 and Joe with £142.18.

Click to enlarge 

The FTSE Small Cap yields £106.43 and £123.17 respectively.

Click to enlarge

Finally, the FTSE All Share shows Bob again going backwards in Real terms with £99.50 while Joe is well ahead with a fund worth £119.64.

Click to enlarge 

So it seems reinvesting dividends remains crucial if you are to build long term wealth as a UK Investor.  My journey towards Financial Independence  has all dividends reinvested.  Does yours?

Assumptions:

• Inflation post February 2013 is estimated
• The Index Tracker fund performance is calculated assuming zero expenses and no tracking error with the actual index