As a dividend growth investor, my goal is to build a portfolio of quality dividend stocks that grow dividends over time. My success in achieving that is dependent on amount of savings I can put to work each month, the returns I can generate and the time I allow the investments to compound.
I believe that consistently saving a portion of my income is the basic foundation behind my financial independence calculation. However, what I do with that money is equally important — because if I am successful, the amounts I earn from investing will be many times what I would have earned during my lifetime. In other words, if I saved $1,000/month for 20 years, I would have ended up putting away approximately $240,000. Let’s assume that I invest it all in dividend stocks that yield 3% today and grow distributions by 7% annually. Distributions are then reinvested in more companies yielding 3%, which grow dividends by 7% per year.
After 20 years, the value of this hypothetical portfolio would be approximately $715,000. It would be earning over $21,500 in annual dividend income. The power of compounding has resulted in a gain of over half a million dollars in net income. This power of compounding was created when earnings were plowed back in the business to maintain and increase profits and have the capacity to increase dividends. Those increased dividends are then also plowed back to buy more shares, which turbocharges the income growth potential.
As you can see, by year 20, the amount of dividends that is earned covers the amount of funds put to work in the portfolio almost by a factor of two. This shows that consistent compounding of capital and dividend income can result in much more funds that those initially put to work. The amounts put to work are really minuscule relative to the ending amounts, after a period of consistent compounding of capital and income.
If you continued compounding for another 30 years, the amounts put would look even smaller, relative to the ending amounts of capital and income.
Of course, this goes on to show that even small amounts of money that are left to compound over long periods of time and a consistent rate of return could mushroom into pretty sizable fortunes. This is why you should never despise the days of small beginnings, but should start investing as soon as possible. The earlier your start, the more time do you have to compound your capital.
For example, if you are 25 years old and you can only afford to put $10,000 to work in dividend stocks once, you can do pretty well over a 40-year period. When you are 65, you can end up with a portfolio earning almost $13,800 in annual dividend income. If you are 50 years old, and you want to earn the same type of income at the age of 65, you need to put $114,000 to work for you. You can definitely see with this example that starting as early as possible lets your dividend stocks do the heavy lifting for you. I have shared the spreadsheet I used to create those calculations here.
For example, one of the largest beneficiaries of the power of compounding is Warren Buffett. He became a billionaire in 1986, at the age of 56. Now, at the tender age of 84, he is worth $58.5 billion. In other words, 98% of this fortune was achieved in the past 28 years. This was mostly done because of the power of compounding.
I keep seeing investors who do not understand why it makes sense to buy dividend growth companies that yield only 2.5% or 3% today. What those investors are missing, however, is really obvious. They miss that those companies regularly manage to grow their dividends, because they are able to increase profits over time. If you start with a 3% yield today, but you grow the dividend by 7% a year for 30 years, you will end up with a stock that pays you a 24% yield on your cost eventually. In other words, if you put $1,000 in a dividend stock that yields 3% today but grows those dividends by 7% per year, you will end up with an annual dividend income of $240 in 30 years. This example of course assumes that you spend all the dividends. If you reinvested those dividends into more stock for 30 years, the annual dividend income produced by that dividend machine would be $520 every year.