The power of compounding

WHETHER saving or investing for your future goals, it’s important to start as soon as you practicably can. That way, you’ll be better placed to maximize the benefits of ‘compounding returns’. This ultimately means that as far as compound returns are concerned, it’s less about how much you can afford to put aside, and more about for how long the money has time to grow.

Compound returns have been referred to as the eighth wonder of the world. The basic concept is that if in the first year of investing you generate capital growth and reinvest the income, this is deemed to be your starting point for year 2. In the second year, assuming the investment continues to grow, you generate further growth and income on your previous year’s return, essentially snowballing over time to produce far more than you might expect.

Investing small sums earlier in an investor’s time horizon can drastically affect their savings for retirement but the power of compounding the annual returns is so great that even missing out on a few years of saving and growth can make an enormous difference to the eventual return.

For example, if you’d invested £5,000 in the FTSE All Share in 1986, and withdrawn any income generated, it would have grown to £28,510 at the end of March 2018. If you’d let your investment benefit from compounding (‘re-investing’ the income and accumulated growth), you would have a total return of £93,100 for the same period. Of course, in investing there are no guarantees and there is a risk you could lose the capital invested along with any reinvested income. However, by investing over a long timeframe, you give your investment time to make up for any losses that may have arisen.

The same story has been repeated across global stock markets and looking at the past 25 years for example, as the table below shows, if you invested in the FTSE 100 index you could have almost doubled your return by reinvesting dividends. In China, reinvesting dividends might have been the difference between making a profit and a loss. The key and consistent outcome is that each index would have returned more if you reinvested dividends. Overall, the average annual growth across these eight markets, without dividend reinvestment, was 4.3%. Including dividend reinvestment increased the average annual growth to 7.1%.

Index	Annual return excluding dividends	Annual return including dividend reinvestment
Hang Seng (Hong Kong)	7.0%	10.7%
S&P 500 (US)	7.5%	9.7%
MSCI World	5.9%	8.3%
MSCI Emerging Markets	5.3%	8.0%
FTSE 100 (UK)	4.1%	7.8%
CAC 40 (France)	4.3%	7.6%
MSCI Japan	1.3%	2.8%
MSCI China	-0.5%	2.0%

Source: Schroders. Thomson Reuters data for the MSCI World and the MSCI World Total Return (including dividends) in US dollars correct as in March 7, 2018.

Numerous studies have shown the positive impact of reinvesting dividends and the resultant compounding effect. In addition, these have shown that income volatility is significantly lower than price volatility and that the longer the time frame, the more significant dividends become over capital returns. Dividends offer more than just income. If they are reinvested, they represent a substantial portion of a stocks’ long-term total return.

Sources
1. Compounding: 8th wonder of the world, FT Adviser – February 1, 2017

2 JP Morgan Guide to the Markets – April 2018

3 Schroders: How reinvesting dividends has affected returns over 25 years, David Brett – March 2018

Please speak to your financial adviser or investment manager at Blackadders Wealth Management for further information.