Would you like a game of chess?
This is not true, and those who ignore the power of compound returns should take heed from a story about a king, a masterful chess player who liked to challenge travellers passing through his kingdom. One day a traveller accepted the kings offer and asked what they would get in the event if they beat him. So confident of victory, the king retorted that the traveller could name his prize. The traveller demanded that should he win all he would want is some rice, albeit grains of rice doubled throughout the chess board.
So, one grain of rice on the first square, two grains on the second, four grains on the third, eight grains on the fourth square and so on, until all 64 squares were covered. The king duly accepted the travellers demand. Unfortunately for the king he lost, but being a man of his word, he asked one of his servants to fetch a sack of rice to fulfil his obligation. He quickly realised that he had been duped, because to fulfil the traveller’s prize he would need 18,446,744,073,709,551,615 grains of rice. This figure is over eighteen quintillion.
The king did not appreciate the power of exponential growth. Of course, reinvesting dividends is not exponential, because any positive rate of exponential growth inevitably causes all available resources to be consumed. However, we believe it does illustrate the potential power of growth, and more importantly, the power this can have on investment returns over time.
Focus on the “real return”
As already mentioned, larger, more established companies pay out profits as dividends, so where better to look at the power of dividends than the FTSE 100:
As you will note in the graph, the blue line represents capital growth only within the index, whereas the yellow line represents capital growth plus income reinvestment (the total return). The period we are looking at is from the 1 January 1986 to present day (5 April 2019).
With capital appreciation the return is 427.53%, whereas with income factored in and reinvested, the return (total return) is 1773.89%! Whilst a return of 427.23% might not sound too bad for some, this figure does not consider the impact of inflation. According to the Bank of England £1 in 1986 would have been worth £2.88 in 2018 – or 288% more. So, the return would only be 139.17%. The ‘real return’ is always what matters in the long term, after all, what does it matter if the value of your money goes up, but it has less purchasing power? This isn’t the case in the above example, however, there would have been other assets considerably less risky than the stock market to achieve the same level of return. This is known as the risk-free rate of return.
Such examples of risk-free rates of return might include holding cash in the bank or holding government securities such as gilts. As you will note in the graph below I have added the Bank of England (BOE) base rate + 1% - an expected return should you hold cash or invest in certain instruments linked to the BOE base rate.
It is surprising to see that over the same period a safe investment such as cash would have outperformed the FTSE 100 on a capital return basis. Hopefully this illustrates the power that income can have on one’s portfolio, and with that income being reinvested, it does offer protection against inflation, but also ensures the rewards of investing in the stock market outweigh the risks.
Opportunity lies in both the rise and fall
Even short-term dips in the stock market can work to an investors’ advantage, as they will be able to buy more shares with any re-invested dividends during these dips. When combined with market growth over the long-term the benefits become even clearer.
As hopefully illustrated, the power of growth is not to be underestimated. But for those yet to be convinced, I thought it would be
fitting to end on another example of the power of exponential growth. Forbes recently announced that Jeff Bezos is the richest man in the word with a fortune of $137 billion. However, if you gift a new born baby $1 on their first birthday and $2 on their second, and continue doubling their birthday gift every year, by the time they are 37 they will have a fortune larger than Mr Bezos’. By the time the lucky birthday recipient has reached 40, their fortune will have exceeded the current market capitalisation (value) of Amazon.
Past performance is not indicative of future performance.
It is not possible to invest directly into the FTSE 100. An investment in shares will not provide the security of capital associated with a deposit account with a bank or building society.
The value of shares and dividends may fall as well as rise. You may not get back to the amount invested.