Take the long-term view and reinvest dividends

DIVIDENDS will play an increasingly crucial role for investors in the low-growth environment of the coming years, experts have predicted.

But while investors may see dividend payments as a way of quenching their thirst for regular income, their real value comes from being patient and reinvesting them.

The last decade hasn't been easy, with two bear markets and an uncertain outlook for the coming years.

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Little wonder that many seemingly canny investors have been suckered into get-rich-quick schemes from "boiler room" fraudsters to Bernie Madoff's multi-billion swindle in the United States, described as the biggest Ponzi scheme in history.

But why take risks when the most effective ways of achieving long-term growth are the most basic? Put at its most simple, the best way to boost returns is to reinvest the dividends you get from income-producing shares and funds.

Around 90 per cent of returns from equities are provided by dividends and reinvested dividends, according to the Barclays Equity Gilt study.

If you had invested 100 in the UK stock market at the end of the Second World War you would have had 5,721 to show for it at the end of 2008, assuming you didn't reinvest the dividends paid out. However, if you had reinvested the gross dividends, that 100 would have mushroomed into a pot of more than 92,000, the study found.

Investors usually get the option of getting the dividend paid as and when it is declared by the company or the fund. This is a popular option at a time when income from savings is so low, thanks to the 0.5 per cent Bank of England base rate.

But Adrian Lowcock, senior investment adviser at Bestinvest, argued that the power of dividends really comes from the ability to reinvest that income.

He said: "The difference is down to two factors. Reinvesting the dividend has a compounding and cumulative effect on the investment. There is a larger sum to earn more dividends from and it will earn a larger dividend.

"The income reinvested should also benefit from pound cost averaging as the dividends will buy more shares at lower prices than higher prices."

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Brian Steeples, managing director at Glasgow-based IFA The Turris Partnership, believes too many investors pay the price for underestimating the long-term impact of reinvesting profits.

The performance of the FTSE 100 in the ten years from January 2000 proves the point, said Steeples, who dubs that period a "lost decade for equities".

The FTSE 100 Index stood at around 6,950 at the beginning of January 2000. Ten years later it was standing at around 5,900, equivalent to a fall of around 15 per cent. But that's misleading, said Steeples, because it doesn't take dividends into account.He said: "The dividend payments made by FTSE 100 companies over the last decade would have provided an increase of around 40 per cent of the value of an investment at the beginning of the decade as opposed to a reported capital loss of 15 per cent. In other words, a 55 per cent difference."

But how does that translate into the growth you could see from your fund investments? Steeples also worked out the returns provided by leading unit trusts and investment trusts over various periods, comparing the returns delivered both with and without the dividends reinvested.

And the long-term results are startling. For example, the Edinburgh Investment Trust, currently managed by Invesco Perpetual's Neil Woodford, has delivered rising dividends since it opened. If those dividends were taken when they were declared, the trust's five- and ten-year returns are 18.1 and -1.06 per cent respectively.

But reinvest the dividends and the returns are transformed into 51.6 and 55.5 per cent over the two time periods.

The pattern is repeated across other income-producing trusts. The ten-year return from the Finsbury Income and Growth trust is impressive, at 69.4 per cent - but that almost doubles to 133.6 per cent when the income payments are reinvested.

And with many income-producing investment trusts paying 4 per cent a year or more - and rising each year - reinvested dividends can have a profound impact on long-term performance.

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"Investment trusts have the ability to hold back up to 15 per cent of dividends received each year thereby creating a 'pool' from which future dividends can be topped up," said Steeples. "This provides a mechanism to 'smooth' the dividend distribution for investors."

The findings are repeated among the unit trusts in the UK equity income sector. Woodford's Invesco Perpetual Income fund, for instance, has produced performance of 6.6 and 62.9 per cent over five and ten years respectively, when income payments are taken. On a reinvested income basis, however, the returns over the same periods are 27.9 and 133 per cent.

Over the same period, the FTSE 100 grew 6.44 per cent when performance is based purely on capital growth, but 56.8 per cent based on capital and income.

Unsurprisingly, experts believe reinvested dividends will become an even bigger part of returns over the next decade, expected to be a period of low growth and low inflation.

Steeples said: "Receiving income in excess of 4 per cent a year in today's marketplace is a worthwhile part of most portfolios. Added to this is the reasonable expectation that this income will rise - and rise at a faster rate than inflation. This makes for a compelling investment proposition."

Investors tend to get their dividends through equity income funds, which invest in companies with a consistent cash flow that allows them to pay out regular and growing dividends.Most equity income funds are UK-focused, but a growing number offer access to income-producing companies worldwide, given greater diversification, better income yields and greater growth potential. Lowcock at Bestinvest recommended the Threadneedle UK Equity Income, Ignis Argonaut European Income and Newton Asian Income funds.

He added: "Investors should be aware they can suffer from a drop off in performance in the short term, which can be due to stock markets being out of favour with the sectors equity income often operate in or focused on another region."

"However, investors should be vigilant and ensure they don't confuse short-term market trends with poor manager performance - to do this (successfully] you need to compare manager performance with his equity income manager peers."

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