What Albert Einstein knew about investing
Albert Einstein, the theoretical physicist, is best known for discovering the law of relativity, but he clearly knew a thing or two about investing as well.
He famously called compound interest "the most powerful force in the universe" and he certainly had a point.
Compound interest is what makes saving money in the bank worthwhile. It can also be the cosmic engine driving your investment portfolio, especially if you buy dividend-paying stocks. So how do you harness Einstein's powerful force to deliver stellar returns?
The good news is that you can feel the power of compound interest simply by paying money into a savings account and patiently letting it grow in value, year after year.
In your first year, you will earn interest on your capital. The following year, you will earn interest both on the capital and the interest you have already earned.
This compounding process repeats itself year after year, which means you earn interest upon interest upon interest. It is like a snowball rolling down a hill, getting bigger and bigger, year after year after year. Provided, that is, you don't spend the interest. You have to leave it in your account to allow the compounding effect to gather momentum.
If you invested US$10,000 (Dh36,731) at 3 per cent a year, but withdrew all the interest every year, you would have $16,000 after 20 years. But if you allowed the interest to compound, your savings would grow to more than $18,000. That's pretty powerful. And when savings rates finally revive from today's miserable lows, the effect will be even more powerful.
The power of compounding isn't so strong when your savings generate just 1 per cent or 2 per cent a year. But there is a faster way to make your snowball: investing in the stocks of global blue-chip companies, many of which offer dividend yields of up to 5 per cent or 6 per cent a year.
Dividends are particularly important in today's turbulent economy when growth is much harder to come by, says Dan Dowding, the chief executive of IFAs Killik & Co in Dubai. "From day to day, investors focus mostly on share price movements. But dividends and, more importantly, dividend reinvestment, can have a much greater impact on your long-term returns."
In the long run, it is the compounding effect of reinvesting dividends that really makes you rich. Say you invested £100 (Dh590.82) in the UK stock market way back in 1899. If you spent all your dividends, it would be worth £22,239 in today's money, according to the long-term Barclays Equity Gilt study. But if you had reinvested them, it would be worth a massive £1.63 million.
It is the same story in the United States, Mr Dowding says. "One-hundred dollars invested at the end of 1925 would be worth $9,229 today if you had spent the dividends, but $299,395 if you had ploughed them back into your portfolio."
The longer you invest, the more important dividends become. "For the seriously long-term investor, dividends are where the action is," he says.
Over 12 months, 62 per cent of your investment returns are driven by market movements, according to a study by Societe Generale, with the remaining 38 per cent coming from dividends. Over five years, just 18 per cent of your total return comes from share price growth, with dividends making up the rest.
There are two elements to dividend return. First, the yield, which is calculated as the dividend payout divided by the market valuation of the company. If the dividend is $5 and the company is valued at $100, the yield is 5 per cent.
The second part is dividend growth. When company profits are growing, they raise their dividends to reward investors. Some companies strive to do this year after year because they see it as a mark of a well-run enterprise.
In the US, Procter & Gamble has increased its dividend every year for the past 56 years. Other familiar US names with a consistent track record of annual dividend rises include Coca-Cola and Johnson & Johnson (both 49 years), Colgate-Palmolive (48 years), Chubb Corp (46 years) and PepsiCo (39 years).
A stock that yields 6 per cent and raises its dividend by 5 per cent a year will double your money in just 12 years from income alone, according to the investment website, Motley Fool. Any capital growth will be on top of that.
Over the long term, the compounding effect of yield and dividend growth will account for more than 90 per cent of your total investment return, says Stuart Reeve, the head of BlackRock's global equity income team. "An investor who started with a $100,000 portfolio in 1970, would now be receiving total annual dividend income of $35,000. That's more than one third of their original investment, every year."
That compounding effect is even stronger than you realise.
There is another advantage to investing in companies with a strong dividend policy, Mr Reeve says. "They tend to be high-quality businesses, whose stocks exhibit relatively low volatility. When the market drops, they will typically fall by a smaller amount and return to profit faster. Over time, avoiding this 'volatility drag' can generate significantly greater returns."
Western companies, particularly in Britain and the US, have traditionally paid the most generous dividends, says Tim Harvey, the director of Offshore Online, an international broker. "That is slowly changing. Japanese companies are starting to pay income. So are many in China and the Far East."
You can cash in on the compounding effect of dividends by investing in mutual funds in the equity-income sector, Mr Harvey says. He tips UK equity income funds such as BlackRock UK Income and Invesco-Perpetual Income and Newton Global Higher Income, an international fund.
The Newton fund's top holdings include Roche Holdings, the Swiss pharmaceutical firm, Bayer, the German health care company, and SSE, a UK utility. All are good, solid dividend payers that more active investors might prefer to buy directly.
BlackRock Global Equity income is another attractive fund. Its top holdings include big name blue chips such as Pfizer, Johnson & Johnson, Novartis and Glaxo.
Albert Einstein isn't the only famous person to appreciate the power of compounding. For John D Rockefeller, the late American industrialist, it made life worth living. "Do you know the only thing that gives me pleasure? It's to see my dividends coming in," he once said.
You may not have as much money as Rockefeller, but you can share in his pleasure (hopefully, you will also find other ways of having fun).
There is one more thing you can do. Manage your portfolio carefully to ensure the taxman isn't taking a cut of your annual dividend income. This is less of a problem if you hold your money offshore, but you may need to seek tax advice.
Einstein didn't get it completely right. There is one force in the universe more powerful than compound interest. The taxman.
Updated: October 13, 2012 04:00 AM