Diana Clement: Reinvest small change for a bigger pot

Compound interest really is magical. It's what you get when you reinvest your income from investments, which in turn grows.

The problem is that unless you've got large sums of money invested, each interest or dividend payment can appear pathetically small. Why save a $15 or $20 cheque, when you can spend it like small change?

The reason to save it is that investment returns will remain small if you don't. Your investments won't grow in the way managed fund providers and others suggest.

The upwards curves they show you in graphs don't happen if that small change isn't added back in as capital.

Take a $5000 term deposit paying interest of 5 per cent a year. Reinvested, it will be worth $6951 at the end of 10 years, assuming a 33 per cent tax rate.

After 20 years it would be worth $9665. It would still be worth $5000 - albeit eroded by inflation - if the interest hadn't been reinvested and compounded.

It's the same with dividends from shares and the income from other investments, including small businesses, if the owners plough the profit back into the business.

Another way to look at your dividends and interest is that they are the passive income that clued-up investors are looking for. It's the money made while you sleep without having to expend your labours to earn it. This income is the icing on the cake for investors.

Jeff Matthews, senior financial adviser at Spicers Wealth Management, said he sat up and listened when he heard a manager talking several years ago about his fund's holding of Phillip Morris International shares.

More than a decade after originally buying the holding, the fund was receiving more in dividends from Phillip Morris than it had paid for the holding in the first place.

Likewise, Matthews cites the Commonwealth Bank's purchase of the ASB in the 1990s.

"Fifteen years down the track the ASB spews out more profit each year than [CBA] paid for it," says Matthews.

You can try this one at home. If you choose the right investment, the same thing will happen to you over time providing you reinvest the income. But don't believe everything you read in literature designed to sell term deposits, funds and other investments.

Too many people in the financial services industry rely on simple compound-interest calculators to make the returns look better than they are. They want you to focus on what you could earn, not what you really receive.

That's because most compound-interest calculators on the internet don't include tax, as I did above. The money Bill English takes from your interest and dividends each year needs to be factored into any compound interest calculation.

Internet-based compound-interest calculators that include tax in the equation are few and far between. The Sorted.org.nz calculator does ask for a net rate of return, not gross. Trying to work out net from the gross is a bit too complex or time consuming for some people.

I'm a great fan of the calculators at Calcxml.com/english.htm. The What Could My Current Savings Grow To calculator at www.calcxml.com/do/sav07 is useful because it takes into account a saver's marginal tax rate (or, if relevant, you could enter your PIR rate for Pie investments).

It shows that a $20,000 share investment returning an 8 per cent dividend yield, which is then reinvested, would be worth $33,712 after 10 years for a 33 per cent taxpayer. On a PIR rate at 28 per cent, the same $20,000 would grow to $35,014.

Most long-term savings or compounding-interest calculators don't take into account tax rates, and would spit out a result of $43,178 for the same $20,000 invested over 10 years at 8 per cent gross, which isn't giving the true picture.

"Lies, damned lies and statistics," as Matthews points out, quoting a phrase describing how the persuasive power of statistics is used to bolster weak arguments.

The other sneaky thing that often confuses investors is that the returns shown by funds, for example, are often a total of income (such as interest or dividends) and capital growth (sometimes called price return). So if you're not reinvesting the income, you're not getting all the growth claimed.

The good people at Morningstar, fired off a couple of useful spreadsheets with their data to me. One highlighted what your price return and total return would have been on an S&P 500 investment. Over 20 years, the annualised price return was 7.03 per cent compared with 9.28 per cent total return, including the income. Likewise, the figures were 5.22 per cent price growth for the FTSE100 and 9.09 per cent total return.

Figures from the NZX50 go back only two years, showing a price return of 2.39 per cent and a total return of 8.25 per cent.

An interesting point about New Zealand equities is that they tend to provide a higher dividend yield than many overseas shares - one reason for the big gap between the two figures.

Matthews says The Warehouse, for example, has a gross dividend yield on the current price of 11.9 per cent, which is 8.1 per cent after tax.

Digressing a little, that's quite a dividend. The only fixed-interest investment I could find in New Zealand that matched that was 12 per cent from Asset Finance - a finance company. No mainstream bank was paying more than 6 per cent for a term deposit of one year or less. The Warehouse's share price can, of course, rise and fall. But the investment is liquid.

The point is that those $15 dividend or interest payments shouldn't be spent. That's a point that Matthews made to his wife recently when she got a form from Pyne Gould asking if she wanted her dividends reinvested. "Tick the box," he said.

"Reinvesting dividends is a compulsory savings mechanism," says Matthews. Ticking the box reduces the administrative hassle if you're receiving dividends by cheque, which some people still do these days.

By reinvesting the dividends, your wealth is compounding much more rapidly and you don't have to make a trip to the bank and fill in a deposit slip or bag, or reconcile the account at the end of every month.

There are two other small advantages of reinvesting dividends and interest. One is that you are dollar cost averaging - that is, dripping money as the market goes through its cycle, buying more shares or units when prices are low and fewer when they are high.

You're also able to invest small amounts at a time without paying brokerage or entry fees. Otherwise it wouldn't be possible to buy $30 of Telecom NZ shares or AMP Capital Growth units. Add these reasons to reinvest into the equation and the benefits start to build.

One trick to consider is buying growth stocks or funds if you're looking to increase the pot. DIY investors sometimes don't recognise the difference - although it is mitigated if the income is reinvested.

I was speaking to one young investor recently who had bought units in the Tyndall Income Fund, because it was popular. This fund is aimed at people who need an income from their investments, rather than capital growth, and the Tyndall Aggressive Australasian Equity Fund or the Small Companies Fund might have been a better bet for a younger investor.

But at the other end of the investor lifecycle comes a time when income is needed for the "spend-down" years. When that time comes, says Matthews, investors can "turn on the tap" and start receiving the dividends.