People invest for a variety of reasons. But mostly the objective for buying shares on the stock exchange boils down to increasing one’s wealth. There are different ways to try and do that. One powerful method I think can have dramatic effects is compounding dividends.
What is compounding?
Imagine you have a single weed in the garden and it scatters three seeds. The following year they grow and each scatter three seeds (and remember, the first weed is still there too, continuing to scatter weeds). Year after year, the process continues. You have probably seen a garden that looks like that – and been impressed or perhaps horrified at how quickly the number of weeds grows.
That can be frustrating if it is your own garden! But it shows the power of compounding. The same principle applies for compounding dividends. For example, Scotts Miracle-Gro currently has a dividend yield of 3.2%. That means that if I invest £100 in its shares, hopefully after a year I will get a total dividend of £3.20. But what if I do not take that in cash, but keep using the dividends to buy new shares? After two years, my investment should be worth £106.50. After 10 years, it will have gone up to £137.
Compounding high yields
That shows the power of compounding dividends. Over time, my initial investment keeps earning dividends. But the dividends themselves also start to earn dividends!
In fact, the impact can be more dramatic with higher dividend yields. Instead of Scotts Miracle-Gro, taking the same approach with 7.1% yielding Legal & General should mean that after a decade, my investment would be worth around £199. If I put the money into 8.6% yielding Imperial Brands instead, my £100 could turn into around £228 in a decade. Or I might go for a share with an even higher dividend yield, like the 12.3% currently on offer at Persimmon. After a decade, my investment should be worth £319!
Risks and rewards
What the above example of a compound returns formula does not take into account is possible changes in dividends and share prices. It assumes they are constant over the 10-year period. In fact they may fall. Then again, they could actually increase. High yields can signify elevated risk. But they can also just mean a share is out of fashion, even though it keeps on making profits and paying its dividend.
But the principle is clear. Compounding dividends over time can lead to dramatic increases in the value of an investment.
Compounding dividends to increase wealth
So, what would I do with this knowledge?
I would not change what I look for in a share. Simply chasing high yields can lead to value traps. Instead, I would try to find great companies selling at attractive prices. Only then would I consider their yield.
On top of that, I would diversify my portfolio. I would be happy owning Legal & General or Persimmon in my portfolio – and I already hold Imperial Brands shares. But I would always own a variety of shares.
Compounding dividends from shares yielding an average 10.6% could help me turn £400 into £1,000 in a decade. With more patience, I could achieve the same results in 15 years by owning shares with an average dividend yield of 6.3%.