Key Points:
Harnessing the power of compounding is a well-documented investment strategy (see “The Power of Compounding In Investing”), which works on the basis of earning additional interest on interest already earned. For example, suppose that from an initial investment of $1000, your investment yields a profit of 10% ($100) after a year, leaving you with total assets of $1,100 at the end of the year. Instead of spending the $100 profit, harnessing the power of compounding means that you would now start the new investment year with $1,100 to invest, and seek to earn a profit not only on your initial $1,000 investment, but also on the additional $100 earned in the first year. In the early stage of an investment, the difference in returns may not be very significant. However, time is a crucial friend of investors seeking to compound returns, and as Chart 1 indicates, the hypothetical returns of a compounding approach versus a non-compounding approach deviate substantially in the later years of the investment. Chart 1: Hypothetical returns with and without compounding Compounding and the Stock Market Having briefly described the power of compounding, how then does compounding apply when one invests in the stock market? By adopting a buy-and-hold approach to stock investing, one is already compounding returns, with the exception of dividends. Over short periods of time, dividends are less crucial, but as our example utilising the local Singapore stock market highlights, the reinvestment of dividends can make a significant difference over an extended period of time. Reinvested dividends had a substantial impact on long-term returns Chart 2: STI Performance with and without dividends Using data from end December 1992 to 22 June 2011, we looked at the difference in returns for the Singapore benchmark Straits Times index based on index performance, and also with the inclusion of dividends. Over the 18.5 year period, the index rose from 1240.34 to 3059.61, representing an annualised return of 5%. With the inclusion of dividends (and assuming no reinvestment), the annualised return was 7%. However, if an investor reinvested the dividends received over the period back into in the stock market, he would have made an 8.4% annualised return. While the incremental return does not appear very significant, it actually added a hefty 99.5% to the cumulative return over the period (a cumulative return of 247.5% without reinvesting dividends, 347% with dividend reinvestment). Reinvesting dividends important, but difficult to implement Even with a seemingly-paltry dividend yield on the market (from 1993 to 2010, the annual dividend yield for STI component stocks averaged just 2.7%), the reinvestment of dividends still delivered a significant improvement to an investor’s returns, highlighting the power of compounding. From a practical standpoint, reinvesting dividends is not such an easy task. Investors who receive stock dividends may find that the amounts of cash received are insufficient for direct reinvestment in the stock market, and may have to accumulate dividends for years before collecting enough to perform a cost-effective reinvestment. In addition, while saving up for a reinvestment in the stock market, investors also incur opportunity costs of being underinvested. Reinvestment easily done via Unit Trusts Unit trusts offer a solution to reinvestment woes in three ways. Firstly, the structure of a unit trust allows for easier and cost-effective reinvestment of dividends at the fund level, since the fund holds a large pool of assets and thus dividends received are also substantial in value. Such activity is performed by the fund manager, which means investors who hold the unit trust do not have to worry about the reinvestment of dividends. Secondly, a large number of funds on the platform which pay dividends have these payouts automatically reinvested, which means that the investor will end up with more units than he originally had. Unlike stocks, fund units can be fractional, which means that payouts of small amounts can be reinvested easily. Thirdly, even if one has the majority of portfolio holdings in the stock market via individual stocks, unit trusts offer a means to reinvest cash dividends (from the stocks) received. After meeting the minimum investment amount (usually $1,000), investors can add as little as $100 via each subsequent investment (for selected funds), which enables stock investors to convert their cash dividends to additional stock market exposure (via unit trusts), thus allowing for further compounding of investment returns.
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| The Research Team is part of iFAST Financial Pte Ltd. |
| iFAST and/or its licensed financial adviser representatives may own or have positions in the funds of any of the asset management firms or fund houses mentioned or referred to in the article, or any unit trusts or Singapore Government Securities bonds related thereto, and may from time to time add or dispose of, or may be materially interested in any such unit trusts or Singapore Government Securities bonds. This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any fund. No investment decision should be taken without first viewing a fund's prospectus. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Past performance and any forecast is not necessarily indicative of the future or likely performance of the fund. The value of units and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer in the website. If you have any queries about the above contents, please contact iFAST. |
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