The Power of Compounding Dividends

Few things in life actually compound. The natural state of disorder in which we live often complicates the compounding process. Investing, particularly via dividends, is an exception. Compounding in this context is extremely powerful. Consider a snowball rolling downhill, accumulating snow and growing larger with each turn. This image depicts the process of compounding investments.

Compounding dividends works through two main mechanisms: receiving dividend increases from the stocks you own and reinvesting those dividends to buy more shares. This dual approach has a compounding effect on both dividends per share and total number of shares owned. Reinvesting dividends allows investors to earn returns on their returns, which can significantly improve overall investment performance.

Dividend growth investors’ journey can be divided into two major phases: accumulation and distribution.

The accumulation phase

During the accumulation phase, investors focus on expanding their portfolio rather than relying on dividend income to cover expenses. At this stage, reinvesting dividends is critical. Instead of simply buying more shares of the company that paid the dividend, astute investors reinvest dividends in the best available buying opportunity at the time. This strategy increases the number of dividend-paying shares in the portfolio, accelerating dividend income growth. The emphasis is on maximizing the compounding effect, which will allow the portfolio to grow more steadily over time.

The Distribution Phase

When an investor enters the distribution phase, they begin to rely on their dividend income stream to cover their expenses, which is common in retirement. At this point, they can “turn on the tap” and begin using the dividend income to fund their lifestyle. The emphasis shifts from reinvestment to utilizing the income generated, resulting in financial independence and stability. This phase represents the culmination of years of disciplined investing and reinvestment, with compounded dividends now serving as a reliable income source.

The Special Third Phase

A special third phase may occur if dividend income exceeds the investor’s expenses during the distribution phase. In such cases, investors can continue to reinvest some of their dividends while using a portion to cover living expenses. This approach allows for the creation of multigenerational wealth via “forever” compounding. Investors can ensure that their wealth grows and benefits future generations by reinvesting a portion of their dividend income on an ongoing basis.

Choose High-Quality Dividend Growth Stocks

Successful dividend compounding is built on a careful selection of high-quality dividend growth stocks. Companies with a track record of consistently increasing dividends are excellent candidates. These companies frequently demonstrate strong financial health, consistent earnings, and a commitment to returning value to shareholders. Investing in such companies allows investors to leverage the power of compounding to accumulate significant wealth over time.

Finally, the dividend compounding strategy provides a solid foundation for financial growth and stability. Investors can maximize their returns and generate a sustainable income stream by engaging in disciplined reinvestment during the accumulation phase and strategic utilization during the distribution phase. Furthermore, the potential for multigenerational wealth through ongoing reinvestment demonstrates the long-term power of compounding dividends. By making informed investment decisions and remaining committed to the process, investors can achieve significant long-term financial success.

If you are not sure which stocks are good for dividend investing or how they should be allocated in your portfolio, talk with a financial advisor, they can help.

 

Please see disclosures here.

GLEN HEDRICK, ADVISOR

The Wealth of Advice is a financial blog that is focused on retirement and wealth information, with a little of everything else sprinkled in.

I manage portfolios for clients and myself at Old North State Wealth Management.

Disclosures can be found here.

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