Dividends are payments some companies make to investors who own shares – distributing profit to shareholders when they see fit. Dividend reinvestment is when shareholders re-invest these dividends back into the company, rather than using the money in other ways.
Dividend reinvestment is similar – although some say more powerful – than the effect compound interest has on savings. Reinvestment increases the number of shares held and – if the company pays dividends in the future – leads to bigger dividend payments as well.
Dividend reinvestment is so important that it is often quoted separately when calculating returns from a share market index, such as the US S&P500 or German DAX. When dividend reinvestment is included, the index is said to be quoted as “total return” terms. When it is ignored, the index is said to be quoted as a “price index”.
Over the short term, movements in the total return and the price index for the same share index do not tend to differ very much. However, over longer time periods (even upwards from a year), the difference can be significant as the effect of dividend reinvestment accumulates.
For example, the MSCI world index (a broad index used by many fund managers to assess their performance against global equity markets) rose 8.1% in US dollars in the year to 09 November 2012. The figure that takes in dividend reinvestment after tax – or the total return –was 10.6%. Looking at a ten year period, the price return was 4.8% a year and total return 6.9%. The difference implies dividend payments of around 2% a year.
In the future…
One of the powerful forces acting against dividend reinvestment is our love of instant gratification. Often people prefer the immediacy and certainty of money now rather than waiting for the chance for a larger reward in the longer term. This tendency is demonstrated in an earlier eZonomics poll and in experiments over the years.
Part of the reason may be because of “hyperbolic discounting” - or thinking of the consequences of decisions less the further in the future they fall. Put dividend reinvesting into context by imagining yourself in the future and being specific about how you would like your future self to live. Seeing an older version of yourself may make the implications of financial choices more vivid – and has been shown to boost retirement savings.