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FOOL'S EYE VIEW
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The humble dividend is often seen as the poor relation when it comes to returns from shares. Its more glamorous sister, the capital return or price appreciation of a share, is far more alluring, not to mention potentially a much quicker way of generating wealth. Who cares about a nice 5% yield when a Sunday newspaper tip promises a price gain of 20% to 30% is on the cards due to a number of equally dubious reasons. Over the long term though, both factors need to be considered if you are to get the full benefit from investing in shares. After all, the value of a share is simply the current dividend it is paying out plus the value attached to all future dividends. The latter is represented by the share price. A change in the aggregate perception of the value of future dividends is essentially what causes share prices to move. When the share price rises, that means the value of future dividends is estimated to be higher and vice versa. Although the movements of the stock market in the last couple of years have caused a lot of people to rediscover dividends once again, it always worth reminding ourselves of the part they have played in overall share returns down the years. The figures vary from report to report, but the post-inflation returns from shares are usually said to be in the range of 5.5% to 8% a year. Of these amounts, around 4% to 5% is said to come from dividends and their re-investment. So it could be said that the price appreciation of shares protects your money from inflation whilst the dividends provide the kicker to outperform assets such as cash and bonds. The situation is similar with the price of property and rental income. Although the former grabs all the headlines, it is actually the combination of the two that makes these assets deliver the goods over the long term. Compounding the error When looking at the effect of dividends on the total return from shares, not only do you have to consider the current payout of shares (for the UK, it is around 3% at the moment), you also have to consider the effect of this money being reinvested and then benefiting from compounding as well. Say you invest your full £7,000 ISA allowance in shares each year and that you have built up a portfolio valued at £30,000 which pay outs £1,000 in dividends each year. If you don't reinvest those dividends, you'll miss out on the 4-5% annual boost that they have traditionally provided. Whilst the difference may seem small over an investing lifetime, it is actually substantial. If you were using our compound interest calculators and including dividend returns without actually reinvesting them, you would get an over-optimistic final sum. In fact in 10 to 15 years' time, if you keep on adding the same level of fresh funds, the annual value of your dividends could exceed your annual contributions. You would then be effectively taking money out of your portfolio each year. The same concept applies whether you are investing in individual shares, trackers or any other sort of fund. If you don't reinvest the money they pay out, the returns you will generate over the long-term could be much lower than you might think. In fact the capital appreciation that your investments generate may not be much more than the rate of inflation. There is nothing wrong with using the income you get from shares of course but you can't expect the get the same level of returns if you do this. As the saying goes, you can't have your cake and eat it. How do you reinvest? When returning dividends to whence they came, as with any sort of investment, it is important to keep your costs down. Many unit trusts offer what is known as 'accumulation units' that reinvest this money for you as opposed to 'income units' that pay out the money as a dividend instead. Savings schemes for investment trusts also provide a low-cost route for reinvesting, especially when the dividends are bundled with fresh money. The same principle applies with individual shares. Reinvesting a dividend of £100 is not likely to be cost-effective. Remember that you don't need to put the money back into the same company or fund. What is most important is that the money is actually reinvested.