Reinvesting dividends: why it could leave you thousands better off

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Reinvesting dividends offers a sure-fire way to boost your returns and increase your chances of outsized gains from your investments over the longer term. But many investors are missing out when picking top stocks and funds to invest in.

Dividends are payments made by a company to its shareholders, representing a portion of the company’s profits. They are a way for companies to share their success with investors and can be paid out in cash or additional shares of stock.

Investors keen not to disturb their capital and to keep it growing, often draw down just the dividends, creaming those extra payments off the top of their fund for an income, especially in retirement as part of a pension. Some investment funds are designed for investors to take dividend income this way.

But while dividend-bearing investments are particularly important for income seekers, long-term academic studies on the returns from UK equities have proven that they overwhelmingly account for most of the real return (after inflation) of the UK stock market.

Jason Hollands, managing director at wealth manager Evelyn Partners, said: “Where dividends are reinvested, rather than taken, this creates a very powerful compounding effect.

“This means investors benefit not just from the returns on the original cash invested, but also the returns on the gains made on the dividends which are ploughed back into further share purchases.”

Reinvesting FTSE 100 dividends

Over the last forty years, the FTSE 100 has made a capital return of 391%. This is equal to 205% in real terms – meaning after inflation – as the UK consumer price index inflation rose 186% over this period, by Evelyn Partners’ calculations.

But with UK dividends reinvested the total return is a far more impressive 1,926%.

Hollands said: “While it can be nice to see ad hoc dividend income appear in your bank account, if you don’t need the income now, it is far better to opt for a dividend reinvestment scheme.

“Or, if you are a fund investor, to choose ‘accumulation’ shares classes where any income from the fund portfolio is automatically rolled up rather than distributed.”

Tom Stevenson, investment director at Fidelity International, said 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,” he pointed out.

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, said Stevenson.

Missing out on dividend reinvesting

Millions of investors could be missing out on thousands of pounds each, however, by failing to reinvest their dividends, according to Aberdeen Asset Management dividend research.

According to Aberdeen’s findings, 42% of UK investors either said ‘no’ or ‘don’t know’ when asked if they are reinvesting their dividends – equal to 7.5 million investors in the UK.

Analysis by Aberdeen looked at nine major markets over a ten-year period to the end of February 2025 and the impact of reinvesting dividends on returns if an investor had started with a £10,000 lump sum investment.

The biggest difference between total return (reinvesting dividends) versus capital return (not reinvesting dividends) was seen in the Dow Jones Index. It delivered £37,016 on a total return basis over 10 years. This compares to £29,651 on a capital return basis – a difference of £7,365 over 10 years.

Some may be surprised to see the Dow Jones Index lead here given the US is not typically associated with dividends. But that just shows the power of the compounding effect and its impact on the higher total return on the index’s performance.

Because while the S&P 500 delivered the largest total return on £10,00 invested over 10 years – at £41,485 versus £34,699 on a capital return basis – the difference between capital and total return was smaller at £6,786.

The FTSE World Index came third, at £32,002 returns on a total return basis compared to £25,439 on a capital return basis; a difference of £6,563.

The difference was most stark when looking at the AIM market. AIM only delivered positive returns after 10 years, and that was only on a total return basis i.e. when dividends were reinvested, returning £11,335 versus £9,851 when dividends weren’t reinvested.

Interestingly, the FTSE100, often famed for its dividends, came in at number five in Aberdeen’s analysis. Over 10 years it provided a total return of £18,548 versus £12,682 on a capital return basis; a difference of £ 5,866.

Ben Ritchie, head of developed market equities at Aberdeen, said: “Reinvesting dividends is key to long-term returns. While the impact has been seen over the past three and five years, it’s not until ten years that the true magic of compounding really kicks in and delivers, assuming that markets are moving in the right direction – upwards.

“Many income investors rely on their regular dividends to meet their outgoings. But it is compound interest that helps get portfolios to sufficient scale so they can reap the income rewards later on.”

Source: Bloomberg, 28 February 2025

Picking dividend winners

As well as the powerful effect of dividend reinvestment, it is worth looking out for reliable, consistently dividend paying companies for another reason.

“A company that is able to pay a sustainable and growing dividend that is amply covered by its earnings per share can be regarded as shareholder friendly and able to generate healthy cash flows,” said Hollands.

However, some caution is also required, especially where the level of dividend yield appears “too-good-to-be true”.

“When buying shares with high dividend yields, it is important not to get dazzled by the highest headline yields without digging deeper into how well supported those payouts are by the underlying profits,” Hollands said.

Targeting higher yielding stocks can be a bit of a trap, as a very high yield can be an indication that the market does not believe the dividend payout rate is sustainable and the outlook for the business is poor, so a low share price creates the effect of a high yield.

It is much better to find companies that have the potential to grow their dividends over time, because the underlying business is performing well.

“It’s also worth pointing out that recently many companies have now adopted share buybacks alongside dividends, which can help enhance shareholder returns, so these might be considered alongside dividends,” Hollands said.