Compounding dividends can substantially increase your returns over time
Albert Einstein once said, “The most powerful force in the universe is compound interest.” He knew the importance of time and starting early.
When you invest your money, the key is to not take out any gains. Instead, re-invest your gains to allow your money to make more money. Compounding is most effective when you start early.
Compound interest is what occurs when interest previously earned is added to the principle and is considered when calculating future interest – i.e. earning interest on interest.
Compounding dividends is much better than compounding interest
Assume that instead of depositing £1,000 in an interest-bearing account, you instead purchase a solid dividend paying stock with a current yield of 5%.
In the first year you will earn £50 in dividends. Which is the same as the 5% interest-bearing account, but that is where the similarities end.
Solid dividend stocks increase their dividends each year. In this example, let’s assume a 10% dividend growth rate. So you will earn £57.80 in year 2, £67.10 in year 3, £78.10 in year 4, £91.70 in year 5, and so on.
Comparing the above two scenarios over the 5-year period, you will earn £276.30 from the interest-bearing account as compared to £374.70 from the dividend stock. That is more than a 35% difference!
Can life get any better than this? Yes it can!
Solid dividend stocks’ dividend yield tends to stay within a given range, so if dividends are increasing each year, the only way to keep a consistent yield is for the price of the stock to go up.
In order to have a 5% yield in our above example at the end of year 5, the stock would have to be worth £1834.40 (divide 91.70 by 1834.40 equals 5%).
Among many others, the characteristic of solid dividend stock is that its dividend increases every year. The rationale here is if earnings increase, the dividend will increase. Even if the percentage remains same, the companies tend to increase dividends with increase in earnings per share.
and you keep holding their shares, there is NO limit
to how much dividend you may receive over time
And it’s exactly these type of high quality companies with increasing dividend payments that I would be considering for the Dividend Income Portfolio.
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