The Importance of Dividends
As we demonstrated in our Investment Philosophy document, the re-investment of dividends can have a huge effect on the overall portfolio performance owing to the effects of compounding. Put simply, every dividend that is re-invested purchases more units, thereby increasing the dividend paid out in subsequent years.
The chart below illustrates this point, using a £1,000 investment with an assumed and consistent 5% yield per annum (for sake of simplicity, the capital value is assumed to remain constant):
As you can see, over a ten year period the difference is £128.90, which is an increase of 25% - this is an additional two and a half years’ worth of dividends if income is paid out from the fund.
The example above shows the power of compounding, and the difference that it can make to a portfolio over the longer term.
As we anticipate holding the units for the full time horizon it is important to view compounded dividends in terms of the yield, not in relation to the current share price, but to the actual price that you paid for the unit.
In the example above we assumed a steady 5% growth, every year throughout the ten year period. When income was being paid out this 5% remained constant, with a £50 dividend being paid every year. However, when dividends were re-invested we saw the dividend increase, up to the final payment of £77.57. When we relate this back to the units purchased with our initial £1000 investment, we can see that the yield we are receiving on that amount is not 5% at all, it is now 7.76%.
Although a simplified view, we can extend this to real world returns by examining the popular Invesco Perpetual Income and Growth Trust, an investment that has provided its investors with a dividend every year since launch:
The launch price of this trust was £1 per share, so we can see that the first dividend represented a yield of 1.75% on any initial investment at launch (1.75 pence dividend per 100 pence share). If you had invested at outset and retained the holding until the present day, the actual yield paid in 2019 on the amount initially invested would be 14.8%, a return roughly fifteen times what is available in cash.