The power of compounding: little and often for a long time

Capital at Risk: The value of investments and the income from them can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.

Most investors understand the concepts of buying low and selling high, not putting all their eggs in one basket, avoiding trying to second-guess the market, or taking on more risk than they can afford. But fewer people know about how compounding can potentially have exponential effects on their returns.

By regularly drip-feeding smaller amounts of money into your investments and then leaving the money there to grow, your return may well be higher over the long term than if you just invested a lump sum. For some people, this could mean upping their pension contribution or investing a little extra each month from their disposable income, but for others it could mean reinvesting their dividends.

Dividends are usually paid once or twice a year to shareholders who have a stake in a company (investors receive a coupon if they own a bond). While some investors treat this money as regular income, others reinvest it by buying more of the same stock or bond, with the aim of benefiting from compounding.

On 31 December 2003, the UK’s FTSE 100 index closed at 4476.901 points1 and it closed on 29 December 2023 at 7,7332 points2, a rise over the 20-year period of 72.7%. So if you had invested £10,000 on the last day of 2003 in a fund that tracks this index and taken the dividends as income, your investment would have been worth approximately £17,270 by the end of 2023. However, if you had reinvested the dividends, that initial £10,000 would have been worth £26,379

The difference is down to you making a return on the lump sum you first invested as well as on the reinvested dividends, which is like receiving interest on the interest.

You can track what to expect from your investment by looking at the dividend yield of a particular index. The FTSE All-Share Index’s current dividend yield is 3.86%,4 for example, which means if you invest £100, you could receive a dividend worth 3.86% of your investment. The yield, however, can go up and down. A dividend yield can be used to assess whether a company is in good health, although company boards can decide to cut their dividends as and when they need to.

If you invest £100 into a stock, reinvest a dividend of £3, and the stock rises , the investment would be worth £108 after 12 months. If the same happens the following year, your £108 goes up by 5% to £113.40 and reaches £116.40 with the £3 dividend. If you hadn’t reinvested those dividends, your £100 investment would only have been worth £110.25.

Note: Index performance returns do not reflect any management fees, transaction costs or expenses. Indices are unmanaged and one cannot invest directly in an index.

Past performance is not a reliable indicator of current or future results. BlackRock makes no representations or warranties as to the accuracy or completeness of any past, estimated or simulated performance results contained herein, and further nothing contained herein shall be relied upon as a promise by, or representation by BlackRock whether as to past or future performance results.

The value of an investment can fall as well as rise and investors may not get back the original amount invested. There is a risk that the entire amount invested may be lost.

Over two years and with the small amount of money used in this example, this may not sound like a difference worth celebrating. But over 10 years or longer, and with a substantial original investment, these returns can add up. To make the most from the effects of compounding, investors usually try to stay invested for as long as possible.

However, no matter how long you stay invested, there are no guarantees you will make back the money you put in. All markets fluctuate and sometimes they can turn against you, negating the positive effects of compounding. If the markets do fall, it doesn’t necessarily mean you should change your strategy, though. Generally speaking, it’s often still worth investing small amounts into an ISA because this can smooth out the market’s peaks and troughs and help you ride out periods of uncertainty.

If you decide to invest in a diversified and professionally managed fund – whether you have a fund manager actively picking securities or the fund simply tracks an index – you should research the right share class in advance. ‘Acc’ means ‘accumulating’, and it automatically reinvests any dividends into the fund. ‘Inc’ stands for ‘income’, so the dividends will be paid to you either monthly, twice a year, or annually.

If you trade individual stocks and bonds, you can choose which option you prefer, and, if you need the income, you can easily withdraw your dividends from the fund. It’s often worth discussing all the options with a financial adviser.

1Source: Bloomberg, 5 April 2023
2Source: Bloomberg, 3 April 2023
3Source: Hargreaves Lansdown, 16 January 2024
4Source:Siblis Research, February 2024