As an investor, you can buy shares in a company so that you effectively have a stake in that business. By owning shares in well-managed businesses, you’ll be aligning your wealth with their success. As a stakeholder, you’ll be entitled to a share of any profits in that business that are distributed as dividends. If you don’t need those dividends today, you can use them to buy more shares, meaning you’ll earn more dividends in the future.
This technique is known as compounding interest
Over the long term, these reinvested dividends can become increasingly powerful. Bear in mind that the FTSE All-Share has grown by 214% over the last 25 years, but with dividends reinvested, this figure trebles to 644%*.
Albert Einstein called this compounding interest effect the “eighth wonder of the world”
Of course, there are risks when you purchase shares in a business. Unlike cash that sits in your savings account, which won’t fall in value, the value of your stock market investments and the income you may get from them will fluctuate, meaning there is the risk of loss.
However, over the long term, the perception of safety from holding on to cash can be seen as both a positive and a negative. While cash won’t fall in value, it won’t rise much either. It’s value will be limited by interest rates – so low rates mean you’ll see very little gain. At the same time, successful companies will be innovating. They will be identifying new ways to improve their products and services, generate more cash and ultimately, increase their dividend payments to shareholders.
It’s worth considering too that, everything being equal, an increasing dividend is generally consistent with a rising share price. So investors can benefit from potential growth in the value of their capital as well as their income.
If you want to take advantage of dividends and compounding interest but don’t know where to start, check out our investing in stocks and shares tutorial