The Importance of Reinvesting Dividends - A look back at the local stock market’s performance since 1993 highlights the importance of reinvesting dividends (Author: iFAST Research Team)

Keypoints:

• The power of compounding in investing stems from earning interest on interest already earned
• While buy-and-hold investors in the stock market are already compounding investment returns, the reinvestment of dividends can be tricky
• Our analysis of returns for the Malaysia equity market indicates that reinvesting dividends made a significant positive impact on long-term returns
• Stock market investors may find it difficult to reinvest dividends received
• Unit trusts facilitate dividend reinvestments in three ways: 1) via reinvestment of income by the fund manager, 2) reinvestment via the creation of new fund units, and 3) low minimum subsequent investment amounts, which allows for reinvestment of dividends earned elsewhere

Harnessing the power of compounding is a well-documented investment strategy (see The Power of Compounding In Investing), which works on the basis of earning additional interest on interest already earned. For example, suppose you start with a RM1,000 investment and you have a profit of 10% (RM100) after one year, leaving you with total assets of RM1,100 at the end of the year. Instead of spending the RM100 profit, harnessing the power of compounding means that you would now start the new year with RM1,100 to invest, and seek to earn a profit not only on your initial RM1,000 but also on the additional RM100 earned in the first year.

In the early stage of an investment, the difference in returns may not be very significant. However, time is a crucial friend of investors seeking to compound returns, and as Chart 1 indicates, the hypothetical returns of a compounding approach versus a non-compounding approach deviate substantially as time goes by.

Chart 1: Hypothetical 10% return

Source: Bloomberg, iFAST compilations

Compounding and the Stock Market

Having briefly described the power of compounding, how then does compounding apply when one invests in the stock market? By adopting a buy-and-hold approach to stock investing, one is already compounding returns, with the exception of dividends. Over short periods of time, dividends are less crucial, but as our testing below on the local stock market shows, the reinvestment of dividends can make a significant difference over an extended period of time.

Reinvested dividends had a substantial impact on long-term returns
Chart 2: FTSE Bursa Malaysia KLCI Performance

Source: Bloomberg, iFAST compilations based on monthly data

Using data from 1 January 1993 to 31 December 2010, we looked at the difference in returns between excluding dividends (index level), with dividends not reinvested, and with dividends reinvested. Over the 18-year period, the index rose from 643.96 to 1,518.91 giving an annualised return of 4.8%. With the inclusion of dividends (and assuming no reinvestment), the annualised return was 6.7%. However, if an investor reinvested the dividends received over the period back into in the stock market, he would have an 8.0% annualised return. While the incremental return does not appear very significant, it actually resulted in a hefty difference in cumulative returns over the period; at 135.9%, 222.0% and 301.9% respectively (Chart 2).

Reinvesting dividends important, but difficult to implement

Even with a seemingly-paltry dividend yield on the market (from 1993 to 2010, the annual dividend yield for KLCI component stocks averaged just 2.7%), the reinvestment of dividends still delivered a significant improvement to an investor’s returns, highlighting the power of compounding. From a practical standpoint, reinvesting dividends is not such an easy task. Investors who receive stock dividends may find that the amounts of cash received are insufficient for direct reinvestment in the stock market, and may have to accumulate dividends for years before collecting enough to perform a cost-effective reinvestment. In addition, while saving up for a reinvestment in the stock market, investors also incur opportunity costs for having idle cash.

Reinvestment easily done via Unit Trusts

Unit trusts offer a solution to reinvestment woes in three ways. Firstly, the structure of a unit trust allows for easier and cost-effective reinvestment of dividends at the fund level, since the fund holds a large pool of assets and thus dividends received are also substantial in value. Such activity is performed by the fund manager, which means investors who hold the unit trust do not have to worry about the reinvestment of dividends. 

Secondly for all the funds on our platform which pay dividends, we automatically reinvest the dividend payouts on behalf of investors. This means that the investor will end up with more units than he originally had. Unlike stocks, fund units can be fractional, which means that payouts of small amounts can be reinvested easily.

Thirdly, even if one has the majority of portfolio holdings in the stock market via individual stocks, unit trusts offer a means to reinvest cash dividends received (from the stocks). After meeting the minimum investment amount (usually RM1,000), investors can add as little as RM100 via each subsequent investment, which enables stock investors to convert their cash dividends to additional stock market exposure (via unit trusts), thus allowing for further compounding of investment returns.