This article shows how the power of reinvesting dividends can really growth wealth over the long run. While this is purely an illustrative example and nothing in investing is guaranteed it helps show the difference this investment approach can make.
While we use the example of a single company for simplicity, it is crucial that investors hold a balanced portfolio of companies to reduce the negative impact from any single investment going wrong.
Dividends play an important role in growing wealth with one study by Hartford funds showing that between 1960 and 2025, 85% of the cumulative total return of the S&P 500 can be attributed to reinvested dividends and the power of compounding.
Total return and how you can make reinvesting dividends easy
A simple way to think about total investment return is to break it down into the moving parts.
Total return is the capital gain/loss (the change in the share price) plus any dividends paid out. Some measurements of total return will assume dividends are reinvested.
It is easy to forget about reinvesting dividends because it is not always practical to invest smaller amounts of money, so make sure the cost of dealing doesn’t swallow too much of the reinvestment.
The good news is that most online investment platforms provide an automated dividend reinvestment service, known as a DRIP.
How does compounding dividends work?
Share prices can move around a lot but the key to compounding is to think about your investments as part ownership of a company and focus on the earnings and cash flow that stem from this ownership.
Growing dividend payments should be used to buy more shares, and this is the core dynamic which drives compounding.
The table shows an investment with a share price of 100p and a dividend of 5p per share equating to a 5% dividend yield. Earnings and dividends grow at 10.5% a year.
The reinvested dividends increase the share count by 5% a year.
Business growth compounds the value of each share (share prices follow profits over time) while dividend reinvestment compounds the number of shares owned.
In the example, the number of shares owned grows from 1,000 at the outset to 2,653 in year 20 and the year 20 dividend payment grows in value to close to your original investment.
A point which is often underappreciated is that wealth creation accelerates over time as the base grows.
It is like a snowball rolling down a hill, the more it rolls, the greater amount of snow it collects. A bigger snowball gathers more snow than a smaller one.
So, growth in the first five years adds just over £1,000 but the same growth rate in the last five years adds more than £10,000 to the pot.
Excluding dividends the investment pot would have only grown to £7,360 which means dividends have contributed 62% of the total return, underlining their importance.
What if dividends were put into a savings account?
As the table shows, the wealth pot created by putting dividends into a savings account is around £8,000 (£19,545 minus £11,509) less than reinvesting them into shares.
Bank deposits are safer than investing in the stock market, but the interest rate paid can often struggle to keep pace with the cost of living.
Martin Gamble: Shares and Markets Writer
Martin Gamble is Shares and Markets writer at AJ Bell. He was previously the Education Editor of Shares Magazine. He has been with the business since 2019.
Martin graduated from the University of Kent in...
