On Dividends, Compounding, and Time Periods.

Einstein reportedly said he regarded compound interest as the eighth wonder of the world.

Some facts and figures that I recently saw in The Financial Times, well illustrate why he might have said that. 

First, let’s look at some of the figures, then turn to what they might mean for Mum and Dad investors.

According to the data, $1 invested in the US stockmarket in January 1930 (as measured by the S&P 500), would have grown to $95 at the end of 2015, with no reinvestment. But, if dividends were reinvested, the end figure grows to $2,796. That’s right, $95 without reinvestment, versus $2,796 with reinvestment. Another way to look at it is the end result is 29 times greater if dividends are reinvested.

But hang on, I hear you say, that is a period of 85 years, and who invests for that long? Good point, but hang in there while I dig a bit deeper.

Over 10 years to the end of 2015, An investment in the S&P 500 would have grown by 106% without reinvestment, but by 185% with reinvestment. Over 5 years, the results are 44% and 69%, and over 3 years they are 25%and 37%.

However, one of the most revealing statistics is the extreme variation over different time periods.

Over the entire period from 1926 until 2015, dividends accounted for 33% of the total return. But in different decades, the contribution of dividends varied greatly – from a maximum of 53% of total return in the 1940’s, to only 14% in the 1990’s.

LESSONS

What can we learn from this? Different people will probably find different lessons, but for my part these are some of the main takeaways:

1. Compounding works. Reinvesting dividends has the effect that the reinvested dividends also earn dividends, in addition to the invested capital. This is at the heart of compounding, but less obvious is the extent to which it builds up over time, and the effect is greater the longer the time period. Just look at the 85-year result, $2,796 with reinvestment, compared with $95 without reinvestment.

2. “The Times You Live In” matter. During the 1990’s, reinvestment added little (14% of total return), but in the 1940’s it added a lot, with 53% of total return. Likewise for the 1950’s, with 50% of total return.

3. Your individual time horizon matters. If you have a long term timeframe (eg you are saving money for retirement, which is decades away), the stronger is the case for reinvesting. However, if you are retired and dependent on cashflow, then reinvestment may not be such a good idea. Dividends can make a big contribution to your income needs.

4. What about Australia. The data is American, but I suspect the effect of dividends would be even greater here. Australian dividend rates are high, and research by The London Business school has identified Australia as one of the best performing stockmarkets in the world. Also, Australia has dividend imputation, whereby resident taxpayers can recoup tax paid by the companies. 

FINALLY

There are no “cure-alls” and no “one-size-fits-all” approach. However, dividends are worth consideration in most situations. 

 

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