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Buying dividend shares is a great way of creating additional income. But using the payouts to buy more shares can help generate better long-term gains. The process of reinvesting dividends is known as compounding and it’s often claimed that Albert Einstein, the German physicist, described it as (i) mankind’s greatest invention; (ii) the most powerful force in the universe; and (iii) the eighth wonder of the world.
Wow.
Unfortunately, there’s little evidence to prove that he said any of these things. But I don’t care. That’s because I know compounding has a potentially transformational effect on an investment portfolio.
Let me explain.
Crunching the numbers
Starting with £10,000 in a stock paying an annual dividend of 3.5%, income of £8,750 could be earned over 25 years. Not bad. But if the income was reinvested each year, the initial investment – after a quarter of a century — would grow to £23,632.
Of course, this ignores any movement in the underlying share price. And it assumes the dividend remains unchanged. Experienced investors know that when it comes to the stock market, there are no certainties.
However, this simple example highlights the advantages of compounding. I’m sure Einstein recognised its benefits, whether he commented on it or not.
In my calculations, I used a yield of 3.5%. This is currently what’s on offer from the FTSE 100. But this is the average. There are plenty of stocks on the index that offer a better return.
As an example, I’ve put together a five-stock portfolio.
| Stock | Dividend yield (%) |
|---|---|
| Legal & General | 11.8 |
| BP | 6.5 |
| HSBC | 5.9 |
| J Sainsbury | 5.3 |
| National Grid | 5.1 |
| Average | 6.9 |
The average of the five is 6.9%. If £10,000 was invested equally in all of them, it means income of £690 could be generated each year.
But by using the dividends to buy more shares, it would grow to £53,020 after 25 years, assuming all other things remain equal. And at this point, a 6.9% yield would offer annual income of £3,658.
Steady as she goes
National Grid (LSE:NG.) is the sort of share that those wishing to take advantage of compounding could consider. That’s because the energy giant has an impressive track record of steadily increasing its returns to shareholders. In cash terms, its 2024 dividend was 20.5% higher than in 2020.
The group manages the UK electricity network and also supplies power domestically and in the US. Although it has a reliable and reasonably predictable income stream, the dividend could come under pressure if earnings don’t live up to expectations. This week’s events in Spain and Portugal have highlighted the major consequences of power failures. If this happened in the UK, National Grid would probably face significant penalties from the regulator.
With a large debt burden, the group’s also vulnerable to increases in borrowing costs. The terms of its licences means it has to spend huge amounts maintaining its energy infrastructure.
Although being regulated has its downsides, it also means the group enjoys monopoly status in its key markets. Therefore, it doesn’t have to spend time finding new customers and fighting off competition.
This has helped the company increase its payout for 20 consecutive years. And it could make the stock attractive to long-term income investors, to hold as part of a well-diversified portfolio.
If he were alive, it might also have appealed to Einstein. Apparently, he once said: “Everything is energy and that’s all there is to it”. Or did he?
