There is a misconception that dividends only matter to people who rely on their investments to generate a steady income in cash. What is underappreciated is how dividends play a role in building wealth over a long time.

They are as important to someone in their 30s or 40s looking to save in their ISA or pension for the next 20 to 30 years before retirement as they are to someone in their 60s to 80s looking for a source of income in their post-work life. They can help turbocharge returns in the accumulation phase and then provide a welcome source of cash in retirement.

Dividends accounted for 69% of the total return from the S&P 500 index of US shares going back to 1960, according to research by Hartford Funds. Reinvesting dividends allows investors to enjoy compounding benefits.

Rather than pocket the dividend cash for use on everyday items, the money buys more shares in the same business. If you repeat that each year, you will own an ever-growing number of shares, so you will receive more dividends which you then reinvest, and the cycle continues.

This year, investors have paid particular attention to two areas. The first is to invest in the ‘Magnificent Seven’ group of tech stocks including Nvidia (NVDA:NASDAQ) which have delivered stellar returns. The second is to look at cash as a sharp rise in interest rates have meant investors can get decent risk-free returns from money in the bank.

Investments can have an advantage over cash as you can often get dividend growth each year as well as the potential for capital gains. However, chasing capital gains from big tech stocks can be fraught with risk.

‘If you look back over the history of equity markets, speculating on capital appreciation driven by growth hasn’t been the way to make money,’ says Jon Bell, a portfolio manager on the BNY Mellon Global Income Fund (B7S9KM9). ‘The way to make money has been to invest in solid companies that pay attractive dividends and then reinvesting those dividends into your portfolio and experience compounding. We lost sight of that concept completely in the era of free money.

‘If you can borrow for nothing, it makes sense to speculate. But as the cost of borrowing rises, it’s higher risk to speculate on capital appreciation. In this environment, relying on dividends should be much more rewarding for investors as it was for lengthy periods of history.’

With rates likely to stay higher for longer and dividend-paying stocks offering attractive yields and trading on cheap valuations, now might be a suitable time to deploy a strategy to take advantage of long-term compounding benefits.

Buying an income fund is an easy route to adding compounding machines to your portfolio. If you buy the ‘acc’ (which stands for ‘accumulation’) version of a fund, you will get the dividends automatically reinvested.

The performance in the first few years may not knock the lights out. This strategy is more likely to be a slow burner, but let the compounding do its magic and you could see significant benefits down the line.

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