Turbocharge your returns by reinvesting dividends

Analysis by Fidelity International shows that an investor who put £100 a month in the FTSE All-Share index over the past 30 years and reinvested all dividends, would be sitting on a portfolio worth £140,585. Had they opted to take the dividends as income, rather than reinvesting, their portfolio would be worth almost half as much, at £70,923.

The more income you keep invested the greater your returns will be, even over shorter periods. For example, if you had followed the same approach of reinvesting dividends on an original investment in the FTSE All-Share over the past 10 years, you would have made £19,382 compared with £15,837 without reinvesting dividends.

Reinvesting your dividends will not be suitable for investors who need to take the money as income, of course. But investors looking to grow their pot over a long period should aim to utilise this simple strategy as it can help build wealth. Given interest rates are still low by historic standards and cash savings and government bonds offer low returns, reinvesting dividends is more fruitful as long as you are willing to add to your equity portfolio.

“While growth-focused investors sometimes treat dividends as the icing on the cake, they can be a large driver of investment returns when reinvested,” adds Tom Stevenson, investment director at Fidelity Personal Investing. “Indeed, over very long periods, a lot of the gains from investing in the stock market can be attributed to the reinvestment of dividends.”

Reinvesting dividends is one of the easiest ways to expose yourself to the power of compounding – particularly if you have a long-term investment horizon. Compounding is arguably the most beneficial factor of investing when it comes to growing wealth – the more you keep in markets for longer, the more you can get out. Research from Interactive Investor shows what happens if annual investment returns were 0.5 percentage points higher over the long term, highlighting that reinvesting dividends back into the market – and therefore increasing your returns – and keeping it invested for a long period can boost your pot substantially.

Effect of extra 0.5 per cent return on £1,000 investment over several years

Source: Interactive Investor

It found a return of 5.5 per cent a year on an initial investment of £1,000, compared with 5 per cent a year, resulted in a portfolio of £14,542 compared with £11,467 after 50 years. There were also gains over shorter periods of time, but pension freedoms have resulted in investors staying in the market during retirement, so 50 years is a realistic investment time horizon.

Ways to use dividend reinvestment to boost returns

There are two main ways to harness the power of compounding through reinvesting your dividends. The first is to invest a lump sum, and make sure you reinvest any dividends as they arise throughout the year. If you are using a tax-efficient wrapper such as an individual savings account (Isa), for example, this would mean investing as much of the £20,000 annual Isa allowance as you can afford as close to the start of the tax year as possible to secure maximum dividend payments.

Of course, not everybody can maximise their Isa allowance at the start of the tax year. So, a second way to benefit from dividend reinvestment is by regularly adding to your holdings through a regular investment plan and automatically reinvesting any dividends that arise. Regular investing plans are widely available across platforms. They allow you to purchase shares and investment trusts at a reduced dealing commission of £1-£2 per trade, and invest as little as £20 a month. Combining dividend reinvestment with a regular investing plan can help smooth out market volatility. Your funds will benefit from an effect known as pound cost averaging – when markets go up and are more expensive, your regular fixed amount plus any reinvested dividends will buy fewer shares. But when markets fall and are cheaper, your money will buy more shares.

“This method tends to be particularly useful during volatile markets, such as we saw during the financial crisis and have seen to a certain extent so far this year,” says Adrian Lowcock, investment director at Architas.

Disadvantages of dividend reinvestment

While reinvesting your dividends offers many advantages, there are some risks you need to consider. Firstly, there is always the risk of not paying attention to the dividends companies offer and being unaware that a company has cut or cancelled its dividend. Not paying attention to dividend policies also means you could miss wider fundamental issues in your investments, according to Nick Kirrage, a fund manager at Schroders.

“Some companies borrow money to pay dividends, to keep investors happy. This is not always a sustainable approach. Borrowing money to pay a dividend could be a symptom of a company with a weak balance sheet," he adds.

To compensate for this potential risk, investors need to properly research the companies they invest in. You should also make sure you have a well-diversified portfolio, so that a cancellation or reduction in dividends at one company does not have too large an impact on your ability to reinvest and grow your wealth.

The reinvesting of dividends may also skew your portfolio in a way you did not intend. You might not want to add more to a holding depending on the company’s prospects, or because the company’s share price has done very well and therefore the holding is now a very large part of your portfolio. So make sure you regularly review your reinvestments and think about the company's prospects.

Meanwhile reinvesting dividends does not mitigate any tax you are liable for on the dividend. This is one of the reasons why it is a good idea to hold any income-generating assets in a tax-efficient wrapper such as an Isa or self-invested personal pension (Sipp). As if the investment is held in an Isa or pension wrapper, there is no tax to pay on the dividends or on realising gains by selling units. But if you hold assets outside an Isa or pension wrapper, any dividends are subject to tax, whether these are paid out or reinvested. In the current tax year, everybody has a dividend allowance of £2,000. But any dividends generated above this amount, which are not held in a tax-efficient wrapper, will be liable for tax at 7.5 per cent if you are a basic-rate taxpayer, 32.5 per cent if you are a higher-rate taxpayer or 38.1 per cent if you are an additional-rate taxpayer.

Costs are another major factor to consider as most platforms and brokers charge investors to open dividend reinvestment plans (Drips). These are the most common type of dividend reinvestment and they use dividend cash to buy new shares in the market. However, there is also another option called Scrip dividend schemes, which allow shareholders to receive newly issued company shares, equivalent to the value of any cash dividend. Scrips have the advantage of not incurring stamp duty or platform trading fees, but few providers now offer them. Those that still do include: Barclays Smart Investor, Equiniti Shareview and HSBC InvestDirect. (see table below)

In terms of Drip providers, there are a few providers who allow you to reinvest dividends at no additional cost to their existing platform fees. One example is Barclays Smart Investor. Its platform fee is 0.2 per cent on the value of funds, 0.1 per cent per year on other assets, with a minimum fee of £4 and maximum of £125 a month. Dividend reinvestment is also available at no additional charge at Bestinvest, although this service is only available for funds, rather than shares or investment trusts. Fidelity Personal Investing also does not charge to reinvest dividends in funds but does for shares and investment trusts.

Other lower-charging Drip providers include Interactive Investor, which charges £1 per trade for dividend reinvestment, while the minimum dividend value required for reinvestment is £10. Selftrade charges £1.50 per trade, with no minimum investment needed, although the value of the dividend cash must be enough to purchase at least one share. The Share Centre charges 0.5 per cent per trade on dividend reinvestment, with a minimum cost of £1 and investment level of £10.

Although the platforms charge involved with reinvesting dividends may not seem like much, it can be inefficient to reinvest small amounts of money. If the dividend payout comes to £10, and you pay £1 to reinvest it, the cost equals 10 per cent of your original return. So, it can be better to build dividends up to a larger sum before you invest them. To make it worthwhile, investors should aim to spend no more than 5 per cent of your dividends on the cost of reinvesting.  

Availability of dividend reinvestment and Scrip schemes

Source: Providers and Investors Chronicle