Over the last few Sundays, we’ve been featuring essays from our CEO, Brian Hunt, detailing the power of great dividend investments.
In today’s essay, Brian continues with the series, highlighting one of the most powerful investment forces on the planet — compounding.
You see, compounding through dividend reinvestment is the ultimate way for the “little guy” to safely build wealth in the stock market. With enough time, the growing snowball of wealth from compounded dividend investing becomes so enormous it’s able to pay bills, fund vacations, and make a major positive difference in your quality of life.
Frankly, the content of today’s essay is one of the greatest financial gifts you could ever give your children. I hope you’ll make time to read it, and share its wisdom with your loved ones.
If you’ve missed Brian’s prior essays, or want to read ahead, you can always visit our InvestorPlace Education Center to access all these classic essays.
How Elite Businesses Allow You to Contribute Less and Make MORE
It’s all about taking a superior performer — and applying the magic of compounding
By Brian Hunt InvestorPlace CEO
Getting paid a reliable and growing dividend is a great thing. Over time, it can produce 13%+ yields on an initial investment that started out at a 5% yield.
But there’s a way to make this great idea even better …
Elite, dividend-paying companies like McDonald’s (NYSE:MCD) and Coca-Cola (NYSE:KO) allow you to harness the most powerful investment force on the planet.
This force is called “compounding.”
Compounding occurs when you place a chunk of money into an investment that pays you a return on your money. But instead of taking the returns and spending them, you “reinvest” them … and buy more of the investment.
By doing this, your dividends earn more dividends and your interest earns more interest.
You can think of compounding returns through dividend reinvestment like rolling a snowball down a hill. As the snowball gets larger, it’s able to gather more snow … which enables it to get larger … which enables it to gather more snow … which enables it to get larger … and so on.
Eventually, you build a snowball the size of a house.
Compounding is the ultimate way for the “little guy” to safely build wealth in the stock market.
Given enough time, a good compounding vehicle (like a Dividend Aristocrat) will turn tens of thousands of dollars into millions of dollars.
For example, let’s say you invest $10,000 in an investment that pays a 5% dividend. Your intention is to compound over the long term.
In Year 1, a $10,000 investment paying 5% in dividends will pay you $500. You take this money and buy $500 more of the investment.
In Year 2, your investment has grown to $10,500, but still earns 5%. That year, you’ll earn $525 in dividends … which you can use to buy more of the investment.
In Year 3, your investment has grown to $11,025, but still earn 5%. At the end of that year, you’ll earn $551.25 in dividends … which you can use to buy more of the investment.
You can see how it works.
After 20 years of compounding, a stake of $10,000 throwing off 5% in dividends will grow to $26,533.
After 30 years, it will grow to $43,219.
After 40 years, it will grow to $70,400.
And remember, this number assumes no further money is added to the program as the years go by … or that the investment produces any capital gains.
As you can see, long-term compounding produces extraordinary effects.
It’s a very important concept for young people to learn … because they have the power of TIME on their side.
The longer you can compound, the more extraordinary the results.
The following example shows just how extraordinary the results can be …
Consider two investors, Robert and Sally.
Robert opens a tax-deferred retirement account at age 26. He invests $3,000 per year in this account for 40 consecutive years. Robert stops contributing at age 65. His account grows at 9% per year.
Sally opens a tax-deferred retirement account at age 18. She invests $3,000 per year in this account for eight consecutive years. After those eight years, she makes no more contributions to her retirement account. Her account grows at 9% per year.
The results of these two approaches are below … and they are extraordinary:
Sally made just eight contributions of $3,000, for a total of $24,000 invested. Robert made 40 contributions of $3,000, for a total of $120,000 invested.
However, Sally started at 18 years of age and Robert started at 26 years of age. Sally started eight years earlier. And those eight extra years of compounding are worth more than all of Robert’s 32 years of extra contributions.
Despite a much smaller total contribution, Sally ended up with more money … and a much, much bigger return on her investment.
This example shows why compounding is such a powerful idea to teach children. They have the ultimate advantage of TIME.
This piece of knowledge is one of the greatest financial gifts you could ever give your children.
In order to put your compounding plans on autopilot, consider using something called a “dividend reinvestment plan,” also called a DRIP.
A dividend reinvestment plan is just what it sounds like. It’s a plan that takes the dividends you earn and reinvests them into buying more stock.
Once you set up a DRIP, you don’t have to do a thing. Again, think of a DRIP as a way to put your compounding plan on autopilot.
You can ask any stock broker to institute a DRIP for you. Any reputable online broker will do it for you. It’s a simple process. You can find directions on your broker’s website or call the customer service department.