Got a dream? Then keep reinvesting

We buy shares to make our money grow. We want to be wealthy in our retirement, perhaps even buy a yacht and sail round the world. If we invest our cash in something that actually increases in value, rather than just lying around in a deposit account, our dreams may come closer to reality.

What few people realise, however, is that real growth in equities comes not from capital growth but from reinvesting the dividends. If you spend the income from your share portfolio, you could find yourself falling well short of achieving your dreams.

Consider the following example of two trusts, each established with £1 at the start of the century, quoted in The Millennium Book: A Century of Investment Returns , an analysis of investment performance published by broker ABN Amro and the London Business School. The first trust paid out all its income, the second used it to buy more shares. By the end of the century, the spendthrift fund had accumulated £161, a return about three times the rate of inflation and enough to buy perhaps a small rowing boat.

But the trust that re-invested all its dividends had amassed £16,946, enough for at least a second-hand yacht. The same holds true over shorter periods. Barclays Capital's annual Gilt/Equity study shows that £100 invested at the end of 1990 had grown to £244 by the end of the decade. Re-investing dividends increases that to £334: a 14.4 per cent annual return, compared with 9.4 per cent if dividends are taken away.

The reason is simple: compound interest. We all see it with our mortgage payments, where an apparently reasonable interest rate adds up to the need to repay three or four times the value of the loan over 25 years. With investments, the compounding works in our favour. Many investors already realise that. Foreign & Colonial, for example, estimates that 90 per cent of regular savers with its flagship trust reinvest their income. But what about those who hold shares directly? Some companies give shareholders the option of taking their dividends as shares, but this is by no means universal. Collecting interim and final dividends from all direct investments and using the lump sum to buy shares once a year would help push up returns, but few people will be that organised.

There are, however, signs that dividends are becoming a less important component of investment returns. Barclays Capital, for example, estimates that the contribu tion has fallen from 5.5 per cent in 1989 to 2.6 per cent in 1999. That is hardly surprising given that some of the fastest-growing technology companies do not pay dividends - Microsoft, for example, has never provided shareholders with income.

But it is also due to demographics. We are all getting older and saving more for retirement. That is pushing up demand for equities, and therefore prices, faster than companies are increasing their dividends. That will ultimately reverse - if only because we will retire and want to cash in our shares.

In the meantime, those who want to get the most out of their shares should keep reinvesting the dividends.