The Power of Compounding Effect by Reinvesting Dividends.

The power of compounding is known to be the 8^th wonder of the world. Compounding is not something new. In fact, it has been practiced by many investors for a long time. I have been exposed to investing via compounding for a long time, however, I only put it into practice 4 years ago to present.

Compounding involves reinvesting all the dividends payout, to let the new shares bought with the dividends generate more dividends in future.

For instance, with a capital of $1,000.00, and a dividend payout of 5%,

The total amount of dividends collected at the end of 20 years will be $2,653.30.

Comparing this with simple interest, with the same capital of $1,000.00, and a dividend payout of 5%, which is collected and not reinvested yearly, the total amount of dividends collected at the end of 20 years will be $2,000.00, which is about 25% lesser compared to compounding. This shows the accumulation will definitely help to build the profit margin.

Before one jumps into investing via compounding effects blindly, it is important to know the 3 requirements it needs before the compounding effects are sufficiently significant. This is especially important if one is thinking of depending on compounding effects to churn dividends for passive income for retirement.

1) Time

As quoted from Warren Buffett, “Compounding interest is like rolling a snowball down a hill.” The longer the slope down the hill, the longer the snowball can accumulate and grow. The length of the slope is referring to the time we have to compound the interest. This is visible in the table above. Comparing A with time horizon of 10 years and B with time horizon of 20 years. Assuming they start with the same capital of $1,000.00 and reinvesting the 5% annual dividends, A will only accumulate $1,628.89 at the end of 10 years, while B will accumulate $2,653.30. As such, it is wise to start this journey of compounding interest as early as possible.

2) Dividend Yield

Dividend yield affects the annual returns the capital amount can generate. Based on the quote from Warren Buffett, if time is the length of the slope, then the dividend yield is the increase in the size of the snowball when it rolls one complete cycle. The higher the dividend yield, the larger the compounded capital will be after a year. As illustrated below, with the same capital of $1,000.00, the difference between a 5% and 4% compounded interest over 20 years result in a difference of 21.1%!

Another way to understand the power of dividend yield is to understand the “Rule of 72”. Dividing 72 with the dividend yield will allow one to estimate the number of years it takes to double the capital. As such, a 5% dividend yield will take 14.4 years to double the capital while a 4% dividend yield will take 18.0 years to do the same.

3) Capital

Capital is inarguably the most important factor in enabling one to live off dividend income for retirement. A 5% dividend yield from a $10,000.00 derives only $500.00 a year, which is hardly sufficient for anyone to live off a year. However a 5% dividend yield from a $1,000,000.00 capital derives $50,000.00 a year, which is enough for one to live off rather comfortably a year. This is the main reason why many young adults are more interested in growth stocks that can 5x to 10x to grow their capital. I believe that is the right way to do it, but my experience tells me that the volatility in the growth stocks makes me nervous. Hence I believe personally, having a strong income-producing portfolio first will make me less nervous when faced with the volatility in investing in growth stocks in the path ahead. This is the main reason why I decided to build up a substantial dividend portfolio before starting a growth portfolio. Yes, this definitely makes wealth-building a much slower process. However, it definitely makes me sleep much better at night, especially during the initial period of the Covid in March 2020, and the most recent tech selloff in January 2022.

Barista FIRE, here I come...!