INSIGHTS

Compounding is a very simple concept based around the fact that over time not only does your capital earn returns, but your returns also earn returns.

This can occur in two ways. Firstly, by reinvesting some or all of the dividends you receive back into the company (ie by buying more shares with this dividend income).

The same is also true for companies. A company has the choice to distribute the returns (or profits) it generates in the form of dividends, or to retain these profits to reinvest in the business.

By retaining some earnings in the business, they too can earn a return on this profit (typically at a higher rate than available at the bank), and this is one of the underlying drivers of company’s value/wealth creation.

In the US, using the S&P 500 index (no reinvestment of dividends) and the S&P 500 total return index (reinvestment of cash dividends) this has resulted in a 2.3% per annum difference in returns. While this might not seem significant, since January 1990 it means the end value of the reinvested portfolio was 99% larger than if you had not reinvested dividends back into the portfolio.