This Small Thing Can Make A Huge Difference To Your Portfolio

This Small Thing Can Make A Huge Difference To Your Portfolio
Theodora Lee Joseph, CFA

about 1 year ago2 mins

A dividend yield of 2% may not seem exciting, but if you’re a long-term investor and willing to reinvest your annual dividends by buying more of the underlying stock, you can make a lot more than you think over time. Most investors buy dividend stocks to generate income, and that can work well if you’re close to retirement and about to see your salary dry up. However, if you’re like me, you might make the mistake of letting your dividends sit as cash in your portfolio or you might spend it – particularly if the amount seems paltry and irregular.

But don’t underestimate the power of compounding: dividends, though small, can drive the majority of your returns if reinvested over a longer period. That’s true for most markets, but especially if you invest in the US, Europe, or the UK.

This chart shows the difference in returns over a 20-year period if you’d simply invested in the market (light blue bars) versus if you’d reinvested your dividends in the market (dark blue bars). The difference is stark. You would have generated 50% more returns in the US, and almost doubled your returns in Europe and in the UK over the same period simply by reinvesting your dividends.

The logic is simple: when you reinvest your dividends in the same company, you get more dividends the following year and the effect compounds. Dividend reinvestment is also a complementary form of dollar-cost averaging. So, rather than being focused on day-to-day share prices, look instead at a company’s long-run ability to sustain and grow its dividends. Thankfully, reinvesting your dividends doesn’t need to be time-intensive. When investing in funds, look for accumulation funds or units that do this for you. Or, when investing in individual shares, set up a dividend reinvestment plan (DRIP) with your broker.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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