But what is ‘compounding’?
Compounding is the effect of growth on growth.
The quote is commonly attributed to Albert Einstein. And how true it is: many an unwary person with a credit card has been caught out by how quickly compound interest can build up.
The good news is that compounding can apply itself positively in the investment world. Invest in shares or bonds (or funds that invest in these for you) and you commonly have the option of reinvesting dividends or interest. But the value of doing this is often hidden.
Using a simple example, by simply watching the value of the FTSE® 100 Index on the news, you would have seen the value on 30 September 2007 as ‘6467’, and on 30 September 2017 as 7373.1
You could be forgiven for doing some simple maths and thinking that if you had been invested in the UK stockmarket over this time you would have made around 14%. You could, in fact, be wrong. Why? Because of two very important, and sometimes overlooked, factors.
Dividends, and Einstein’s eighth wonder: compound interest.
The positive effect of dividends
The return of 14% that I mention above is the growth of ‘capital’ only. But almost every company will pay a dividend to their shareholders on a regular basis – often once or twice a year. Investors can choose to either spend or reinvest these dividends. Relative to its total size, the dividend paid per year in the FTSE® 100 is currently around 3.9%.1
If you had reinvested all dividends, your return over the last 10 years wouldn’t have been 14%, but a whopping 66% – these figures assume a single investment from the start .1
It’s worth pausing to highlight this point… Over half of your return (52%) would have come from reinvested dividends.1 Of course, charges may have an impact on your overall return.
An important statistic, yes. But you may be thinking that the size of dividends is quite small, so how is this possible?
The power of compound interest
Let’s recap – compounding is the effect of receiving growth on growth.
As an example, if you have £100 and invest it, any growth you get is applied to the £100. In the next year though, any growth is applied not only to your original £100, but also to the growth that you reinvested. This happens year on year and a ‘snowballing’ effect occurs – every year the impact is slowly magnified.
This difference may be small over one year but, given time, compounding can build up significantly. And over longer time periods, it can make a significant difference to the value of your investment. Of course, there’s no guarantee that your investment will rise in value over time.
In the earlier example, 52% of your returns would have come from dividends. We can crudely identify that roughly a third of this would have been due to ‘compounding’. And that’s over the last 10 years – a time period where the stockmarket has seen its fair share of ups and downs, including the financial crisis.
Well, I’m hoping the next time you see the value of the FTSE® on the news that you know it isn’t giving you the full picture – i.e. no dividends are included. If they were, the value of the FTSE® would be over 9000 over the last 10 years.
More importantly, the next time you take out a Stocks and Shares ISA, or any investment which produces income, you may get asked if you would like to reinvest the income (this could mean you select the ‘accumulation’ option when picking a fund). Unless you’re investing specifically for an income, for example when you’re in retirement, I’m hoping you don’t need to be Einstein to work out that it may be worth tapping into the opportunity to increase any growth by reinvesting it.
Always remember that there are no guarantees – the value of your investment can go up or down, and may be worth less than you paid in. Past performance is not a guide to the future.
The information in this blog should not be regarded as financial advice, and is based on our understanding in October 2017.
1Sources: Thomson Reuters DataStream (for dividends, constituents, prices, yields) as at 13 October 2017.
Financial Express for cumulative performance (30/09/2007 – 30/09/2017).
All rights in the FTSE® 100 Index vest in FTSE International Limited (“FTSE”). “FTSE” is a trade mark of the London Stock Exchange Group companies and is used by FTSE under licence.