Compounding Wealth: Harnessing the Power of Reinvesting Dividends for Financial Growth

Dividends are often the overlooked ingredient in the long-term success of a portfolio. No, I’m not saying you should have a portfolio of only dividend paying stocks. Although, it would not be the worst thing depending on your goals and needs.

Before I go any further, let’s cover what exactly is a dividend. If you poke around the internet you will see varying definitions. Most of them are correct and wrong at the same time. The most common definition of dividend found on the internet is as follows.

– A dividend is a distribution of profits from a company to its shareholders.

In most cases this definition is correct. But, companies can borrow money to pay dividends. So, it is possible that an unprofitable company pays a dividend.

Good or bad?

Let’s talk about why companies pay dividends and if it’s a good sign or bad sign. Companies pay dividends for many reasons.

  • Dividends can provide certainty of a company’s financial well being
  • A strong dividend history can attract investors to a stock
  • Dividends can represent a company’s faith in its future earnings power

Alternatively, there are some that argue dividends reflect negatives. In particular, some will argue that better management would find better uses for money. The idea here being money paid as dividends could go to expanding the business. This argument is not wrong but, there are plenty of mature businesses that can do both.

In the early stages of a company’s life it makes sense that cash is used to grow the business. Re-deploying cash into the business as it moves through its early growth phases makes sense. Then there is that stage of maturity, when competition appears and the opportunities for high growth has diminished. It is sound thinking that a company allocates cash only to projects where it can achieve high returns. The rest should pay down debt or go to shareholders. Why would management plough cash into the company regardless of opportunities?

The fact of the matter is that investors need to form their own opinion of whether a company should pay a dividend.

Why dividends are important

While dividends are important to investors, it’s the reinvestment of the dividends that matters most. The compounding growth opportunity is one that all investors should take advantage of.

Consider the chart below that outlines an investment of $10,000 in the Vanguard 500 Index fund in 1980. From this point I broke out the returns into three categories. First, is the price return of the fund assuming no dividends paid (red line). Second, is the total return which is the price return with dividends paid in cash (yellow line). Third, is the total return with dividends reinvested in the fund (blue line). No, I do not recommend people buy index funds. I used the index fund only for a simple example of a broad investment experience.

My dividend approach

When looking for companies that pay a dividend first I look for moat stocks. Then, I look for consistency in payment as well as the company’s ability to increase the dividend. The Standard and Poors company keeps track of such companies. They created, what they call, the Dividend Aristocrats list. To be on this list a company must be in the S&P 500 Index and have paid and increased their dividend for at least 25 years.

There is also a similar list for companies in the MSCI Europe, Asia and Far East Index (EAFE). This list of foreign companies sets the hurdle at 10 years of paid and increased dividends.

I aim to have 1/3 of my portfolio in some of the dividend aristocrats – both domestic and foreign companies. I also own plenty of other companies that pay a dividend but that is not one of the reasons I own those stocks. My goal in having 1/3 of my portfolio in these companies is to have a solid core of less volatile stocks. And, yes I have dividends set to be reinvested automatically.

Conclusion

The primary benefit to having a dividend focus to holdings is the systematic approach to buying. Regardless of price, you accumulate shares as dividends are paid. This kind of discipline takes the investor off the desire to time investments. The result is also a group of core holdings to ballast your portfolio.

Good luck out there.

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