Dividend magic

When times are good and companies are doing well, dividends are a welcome reward to investors who have backed these businesses.

But there are also the lean years, when a company might not pay anything at all; in the aftermath of the financial crisis, several major banks simply couldn’t afford to. And in the wake of COVID-19, investors are unlikely to see the consistent dividends they may have become used to.

Even in a good year, dividends can appear unexciting – at best, they offer only a few pence on the pound. The impact on your total capital barely seems to move the dial – in the short term.

Yet over the long term something miraculous begins to happen, something that Albert Einstein reportedly named as man’s greatest invention and called “the eighth wonder of the world”¹. That something is compound interest; and reinvesting dividends achieves a similar effect. The power of compounding lies in the exponential rate at which it increases the value of the initial capital sum over time.

One of the more remarkable implications of this compounding-via-dividends effect is that a temporary fall in the share price can in fact have a silver lining. So long as the company continues to pay a dividend, then the shareholder who reinvests his or her next payment will receive a greater number of shares as a result.

Not only does this help to balance out the loss in capital value, it also means the investor is effectively buying up more shares when they are cheaper; yet doing so without committing fresh capital.

In short, dividends are far more than a seasonal bonus. Over the long haul, they can even end up doing most of the work.

¹ It is far from clear that he said either of these things, but they have been attributed to him for decades