How dividends can turn losing stocks into winners

Dividends are a wonderful thing and the extent to which they can magnify your investment returns is often underestimated, particularly by newcomers to the stock market.

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It's no exaggeration to say that over long periods the power of reinvesting dividends produces a return spectacularly in excess of the simple capital rise of a share or stock market. For example, data from Morgan Stanley/Woodford Asset Management shows that £1,000 invested in the UK stock market in 1926 would be worth a bit over £100,000 today. However, with dividends reinvested, that same £1,000 would be worth a whopping £7.8m.

The miracle of compounding is one reason why we here at The Motley Fool advocate playing the long game. That's to say, start investing as early as possible (if you're free of expensive debt, such as credit cards), reinvest your dividends and give compounding time to do its work.

Dividends in action

A widely diversified portfolio of dividend-paying stocks is one of the surest ways to build your wealth over the long term. Furthermore, even over relatively short periods, you may be surprised how reinvesting dividends can turn a losing stock into a winner. Let me show you an example.

Back in April 2007, the stock market was riding high. If you happened to have used that year's £7,000 ISA allowance to buy shares in banking giant HSBC(LSE: HSBA), you'd have bagged yourself 753 shares, paying 930p a share. Of course, this was shortly before the worst financial crisis in a lifetime and today, as I'm writing, the shares are trading at a mere 640p -- over 30% lower than in April 2007.

The table below looks complicated but bear with me and I'll explain.

So, 753 shares bought for £7,000 in April 2007 are today worth £4,819 (column 3) -- that loss of over 30% I mentioned earlier. On no anniversary of the purchase was the value ever above the original £7,000, and at its worse it was less than half that value at £3,388 in 2016

A depressing state of affairs. However, dividends paid on the 753 shares (column 5) make a difference. These add up to £2,395 which, together with today's £4,819 value of the shares, gives a total investment return of £7,219. Admittedly, not great but dividends turned a loss of over 30% in the value of the shares into a positive total return of 3%.

The last three columns in the table track what would have happen if the previous year's dividends were used to buy more shares every April. By reinvesting dividends, the original 753 shares would have increased to 1,254 and the original £7,000 investment would be worth £8,026 today -- a return of 15%.

Now, this is still hardly exhilarating but it does demonstrate the power of dividends, even for a bank that slashed its payout (column 4) during a devastating financial crisis.

Diversification

Of course, if you happened to have invested in bailed-out bank Royal Bank of Scotland instead of HSBC, there have been no dividends to reinvest since the financial crisis and even when they do restart, you may never make a return on your original investment in your lifetime.

However, with a widely diversified portfolio, the compounding effect of reinvesting dividends on your successful stocks should far outweigh the occasional disaster.

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G A Chester has no position in any shares mentioned. The Motley Fool UK has recommended HSBC Holdings. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.