The importance of re-investing dividends

As investors we focus on the performance of key indices, like the FTSE 100 and S&P 500. That’s not surprising; each day’s closing level is quoted on the news bulletins and given pride of place at the top of every financial website. It’s a kind of shorthand for the health of the economy and the national mood.

But the index only tells half the story because it is a measure of the capital value of the stock market. It pays no attention to the other important element of our investments - the income they generate. The return an investor enjoys from their portfolio is a combination of both income and capital growth. And over time it is the growth of reinvested dividends that contributes the lion’s share of our returns.

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One consequence of this is that markets such as the UK, which traditionally pay investors high dividends, can look like worse performers than in reality they are. When we looked into the benefits of re-investing dividends, we discovered that the UK shapes up surprisingly well against apparently more turbo-charged markets like the US.

Not such an ugly duckling

A myth has built up that the FTSE 100 has been a serial underperformer. And when you look only at the headline index level, it’s not hard to see why. The UK’s blue-chip index peaked at 6,930 right at the end of the last century - literally on New Year’s Eve 1999. It didn’t get back to that level until February 2015 and then took another nine years to finally make it to 8,000. It’s been a long hard slog.

But when you factor in the relatively high dividend yield on UK shares, often above 4%, the total return from UK shares starts to look a great deal more interesting. Reinvesting dividends meant that the FTSE 100 got back to its 1999 high much more quickly - by February 2006 rather than February 2015. Today the total return index stands more than three times higher than at the peak of the dot.com bubble.

Sticking with it

Most of us do not simply invest a sum of money and come back 25 years later. So, to make our analysis more relevant to the average investor, we analysed what would have happened to someone making regular contributions on a monthly basis over various periods.

We calculated the returns generated by investing £100 a month into the FTSE 100 over 5, 10 and 25 years. The results were striking.

Someone investing £100 a month from April 2020 to March 2025 would have contributed a total of £6,000. Had they kept hold of their dividend income and spent it, their shares would have grown to £7,196, while re-investing the income would have resulted in a total pot value of £7,989. Even over a relatively short time period, they would have increased the value of their investments by nearly a third. Please remember past performance is not a reliable indicator of future returns.

But it is over longer periods of time that things start to get more interesting. Investing the same £100 monthly over ten years from 2015 to 2025 would have turned £12,000 into £14,764 in capital growth but £18,132 with income reinvested. That’s the difference between growth of 23% and 51%. Over 25 years the comparable growth rates are 47% and 155%. The total £30,000 invested turned into £44,187 in capital growth terms but £76,397 with dividends reinvested.

Small can be beautiful

When we performed a similar analysis on the FTSE 250 we found a similar effect. Over each time period, there was a significant benefit from re-investing dividends. And over the longest period of 25 years, while the percentage uplift from income reinvestment was less than with the FTSE 100, the amounts involved were much greater.

Investing £100 into the FTSE 250 from 1999 to 2024 turned a total £30,000 contribution into £59,204 in capital growth terms, an 97% gain, but £93,436 with income re-invested, a 211% gain.

The sequence of returns matters

One of the most surprising findings of our analysis was that over the full 25-year period the total return from the FTSE 250 index was very marginally better than for the S&P 500, which most investors would probably think had been the outstanding stock market index over that period.

Important information - - investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. Select 50 is not a personal recommendation to buy or sell a fund. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.