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Compound growth investing – the eighth wonder of the world?

Is compound growth really one of the most "powerful forces in the universe"? Here's our take.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

Centuries ago a powerful king was looking to reward a loyal and clever servant. He offered the servant anything he desired.

The servant requested a single grain of rice which he then placed on the first square of a chessboard. He asked the King to double it every day until the board was full; placing two grains on the second square, four on the third, eight on the fourth and so on until all the squares are filled.

Seeing what he thought was a modest request, the King agreed. Little did he know that by the time the 64th square was filled the board would contain over half a trillion tonnes of rice.

Now, 18,446,744,073,709,551,615 grains of rice probably isn’t top of many investors’ wish lists. But the principle of small incremental returns stacking up over a prolonged period is right at the heart of what it means to be an investor and what potential there could be.

Compound growth investing

If a company generates a profit it has two options. It can either reinvest those profits back into the business, or it can return them to shareholders through a dividend. Either way the total value of your investment has increased – either because you now hold a cash dividend or (all things being equal) because the value of the company shares has increased.

This kind of investment growth isn’t going to make you a millionaire overnight. However, over longer periods small incremental growth can help generate impressive results. Remember though all investments and any income they produce, can fall as well as rise in value so you could get back less than you invest.

Dividend reinvestment is probably the best example of this kind of growth in action. And while dividends have been hit hard in the current crisis, large UK companies like Shell and BP have continued to offer sizeable prospective dividend yields though remember all yields are variable and not guaranteed. Past performance should not be seen as a guide to future income.

Dividend reinvestment – grains of rice we can all get involved in

When a company pays a dividend, investors have two options. They can take the money as income or reinvest it (either in the company or elsewhere in the stock market).

Consider the example below. Two investors each hold £100 worth of shares in Rice & Co., paying a 5% dividend. Assuming the shares don’t change in value, after five years Investor A, who has chosen to take the income, will have received £25 of income. They’ll also still have their £100 original shareholding, so will have a total return of £125. However, Investor B who has reinvested their income, will have £127.63.

The longer the shares are held for, the greater the potential difference becomes. After 40 years the total value of investor A’s shareholding plus all the income received is less than half that of Investor B’s shareholding.* In reality dividends and overall returns will vary depending on the underlying investments and past performance is not a guide to future returns. You could make a loss and get back less than you invest.

Holding Years Cumulative income from dividends (£)* Value of Rice & Co. shares without reinvesting (£)* Value of Rice & Co. shares with reinvesting (£)*
1 5 100 105
2 10 100 110.25
3 15 100 115.76
4 20 100 121.55
5 25 100 127.63
10 50 100 162.89
40 200 100 704.00

*This is an example only, dividends from stocks and shares are not guaranteed and the value of investments can go down as well as up in value. These calculations don’t account for charges or taxes. Returns will vary and tax rules can change.

This effect is called compounding, something Albert Einstein is said to have described as “the eighth wonder of the world”. It’s one of the reasons we always advocate a long run approach to investing. It’s also why dividends account for the majority of returns from the UK stock market over the long run.

Because the stock market has tended to increase in value over the longer term, the effect of compounding in the real world can be even more dramatic than in our example.

£1,000 invested in the FTSE 100 in December 1985 would’ve been worth £4,614 at the end of October this year if dividends had been taken as income. But had they been reinvested it would have been worth £16,612.

The power of dividend compounding is clear. Although remember the next 40 years will of course be very different, and past performance is not a guide to future returns

Value of £1,000 invested in the FTSE 100 since 1985 – with and without dividend reinvestment

Past performance is not a guide to future returns. Source: Lipper IM, 31/10/20.

With those sorts of differences at stake, it’s perhaps no surprise that Einstein is said to have gone on to describe compound growth as “the most powerful force in the universe”.

We think that’s the kind of thing you want working in your favour when investing. It’s never a good idea to try and pick ‘the next hot stock’. While compound growth doesn’t perhaps have the same glamour and excitement, it could help over the long-term – and that’s what matters.

If you select automatic reinvestment for shares, investments trusts or ETFs in any Hargreaves Lansdown account, you will be charged a 1% dealing fee (subject to a minimum of £1 and maximum of £10). This charge doesn't apply to funds. View our charges.

This article is not personal advice. If you’re not sure if a certain action is right for you, then you should ask for advice.

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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