Dividend reinvesting is one of the most important concepts when it comes to growing your wealth over time. Research has shown time and again that investors who reinvest their dividends tend to outperform those that don’t over time. The outperformance can be huge and could be in the double to triple digits over the long-term! Have a look at this example on Galxosmithkline (GSK) to see how dividend reinvestment would have boosted returns.
What is Dividend Reinvestment?
In short, dividend re-investment is a strategy that allows investors to own more shares or units in a fund without putting their hand in their pocket for more cash beyond the original investment.
Let’s look at an example to understand how this works. Say you own £20,000 worth of shares in Company A. This pays 5% dividend each year, equal to £1000 on your £20,000 investment. If you reinvest that £1000 in more Company A shares, you will have an investment worth £21,000. Fast forward one year and your 5% yield on the bigger-sized investment equals dividends worth £1050 – so £50 more than you got last time. If you reinvest that £1050 in more Company A shares, your overall pot will be worth £22,050. A 5% yield a year later on that pot equates to £1,102. That’s £102 more in dividends than you received two years earlier. You can see how your dividend keeps getting bigger each year, so too the size of your overall investment – and that’s without assuming any share price appreciation. If you keep recycling your dividends into buying more shares or fund units, in time you can really power up the value of your portfolio.
Reinvesting dividends does not have to be in the same company as seen from the example above. As an individual investor, you are free to chose how to allocate your capital. You can if you like use the dividends from Company A to fund your investments in Company B and Company C. The important concept is to remember to reinvest your dividends in more cash generating assets as opposed to spending it don the pub.
Dividend Reinvestment Real Time Example
To show you the power of dividend investment in real time, have a look at how I have re-invested dividends to great effect in my portfolio.
Since I bought my shares in a dividend paying company back in August 2015, I have received a total of £3,700 in dividend income from companies across my portfolio. Now this is money I could have used to go on holiday, buy a car or simply pay the bills. But I know the importance of reinvested dividends and it’s power to compound over time. I know the concept of making my money work hard for me. So instead of spending the money, I used it to buy shares of dividend growth companies so that I could receive even more in dividend income.
One of the shares I have bought with my dividend income is Imperial Brands (IMB). In total, I have spent £3620 buying 115 shares in IMB. Thus I have essentially gotten my hands on 115 shares in a great company like Imperial Brands for free as I have not had to reach into my pocket to buy any shares. All the shares were bought using the money great companies like BP, Royal Dutch Shell and Coca Cola have sent my way.
For this investment, IMB is expected to throw £195.50 my way over the next year. And you guessed it, when IMB pays these dividends, I will use it to buy even more shares in great dividend paying companies. Essentially, my dividends are making even more dividends. I am using money to make more money. The way I look at it, I got IMB shares and all its future income generating capability for free. Now that is one heck of a deal.
This just goes to show you the power of starting your investing journey early. If you wait till a future date to start saving and investing, you will be giving up on a whole lot of dividend income in the meantime. And by giving up on dividend income, you will be giving up on getting shares for free. So if you are thinking about investing in cash generating assets, the sooner you start the better. You don’t want to be giving up on those compounded returns. Truth be told, it is scary how powerful compound interest truly is. If you had £20,000 in savings by the time you were 30, parking it in low-cost, good stocks that earned the same rate of return as the stock market for the past century would result in £1,600,000+ by the time you were Warren Buffett’s age. That assumes, of course, that you never add another penny in deposits to your investments, instead spending everything you earn outside of the portfolio for the rest of your life.