What the hell are dividends? To put it simply, Dividends are payments, usually made quarterly (every 3 months), that a company gives to it's shareholders, usually a percentage for each share of stock. The Dividend payments usually come from the excess profits a company makes. It's a way for the company to thank its investors for investing, a little gift they give out each quarter. Now, as an investor we have the option to cash out the dividends and make income or we can reinvest dividends. Usually, it's advisable to reinvest dividends in order to grow your nest egg quicker over time.
Remember, compounding interest on a larger nest egg, results in higher dollar amounts of growth. For example, getting a 10% return on $10,000 is better than getting a 10% return on $1000. The bigger the nest egg the more in dollars of compound interest you get. Now, if we reinvest our dividends then the nest egg grows even faster and the dollar amounts we earn in compound interest increase at a faster rate. We want our nest egg to snowball in growth as quickly as possible and reinvesting dividends is a great way of doing that along with Dollar-Cost Averaging. Compounding Interest on Compounding Dividends equals a larger nest egg sooner in your life. Want to see how big of a difference reinvesting dividends can make in building your nest egg? Take a look at the graph below taken from "The Little Book of Common Sense Investing":
*A little side note:* there are two sources of income when investing in the stock market--Dividends (which I just explained above) and Stock market appreciation (The prices of your stocks going up). Together--Dividends and Stock Market appreciation--equals TOTAL RETURN OF THE STOCK MARKET. This is important to know when looking at the graph above. Lets take a closer look shall we?
Exhibit 1 to the left shows two paths that a $10,000 investment took over a 90 year span. The dotted line shows the path of that $10,000 investment as it grows from only stock market appreciation. I have circled the end amount in red. At the end of the 90 year period, the initial $10,000 investment, from stock market appreciation alone, grew to $1.7 million. Not bad. But what if we reinvested our dividends during the same time frame?
Well, the solid line shows us the path that same $10,000 investment took, however, this time dividends were reinvested. Over the same 90 year period, our $10,000 investment grew to $59.1 Million! (Circled in green) Thats a difference of $57.4 million!!!! See how much of a difference reinvesting dividends can make when investing for the long term. We, as layman investors, must take advantage of not only compounding interest, but compounding dividends as well.
This is a really important and simple concept for the layman investor to take advantage of. Reinvest your dividends and grow your nest egg to it's critical mass and then one day 20-30 years from now you can live off of the dividend income, or at least have a passive stream of income on top of the other work your doing! That's the mindset: to build multiple streams of income that we can live off in the future. The sooner we start, the better. The problem arises, however, when we invest in mutual funds or other costly assets that eat up our dividend yields. More on that in the next blog.