Interest compounding is a powerful investment principle, but dividend growth compounding multiplies the benefits of exponential growth. Compounding growth begins when interest or dividends are added to the principal, so that from that point on, the interest or dividends that are added also begin to earn interest or dividends. Compound growth is not linear growth but geometric or exponential growth. Even though the growth rate may remain the same, the amount of interest or dividends each time period is not constant but increases each successive period of time. The increase in the amount of growth becomes larger and larger each time period. This makes time the most important element for taking advantage of this wealth building strategy.
Here is an illustration to compare and contrast investing in fixed rate investments such as a CD or bond versus investing in dividend stocks. In our example Investor A chooses to purchase a fixed rate investment which earns 4% and will reinvest the interest each year. The powerful benefits of compounding are illustrated by the fact the amount of interest each year becomes larger and larger even thought the interest rate remains at 4%. In 30 years the investment grows over 3 times as big as the original investment. In 50 years the value increases to over 7 times the original investment.
Investor B decides to invest in dividend stocks with the same 4% yield Investor A is earning. But Investor B invests in mature companies with solid balance sheets, strong management, rising cash flow, and a history of growing dividends. Our example assumes a very modest 3% annual dividend growth rate. Because these companies’ dividends paid increases 3% per year, we again assume a modest 3% gain in share price per year. In 30 years the stock portfolio increases over 7 ½ times more than the original investment. In 50 years the portfolio grows 30 times the original investment. Our example is a conservative one. Imagine if Investor B were able to consistently purchase stocks that grow faster that the modest 3% in our example.
INTEREST COMPOUNDING / DIVIDEND GROWTH COMPOUNDING
Stable Annual +3% Share Total Total
Yr. Int. Int. Value Div. Price Div. Shares Value
1 $4.00 $4000 104,000 $4.00 100.0 $4000 1040 104,000
5. 4.00 4679 121,664 4.50 112.5 5264 1217 136,926
10 4.00 5693 148,024 5.22 130.4 7429 1480 193,116
15 4.00 6927 180,094 6.05 151.2 10474 1800 272,335
20 4.00 8427 219,112 7.01 175.3 14765 2190 384,092
25 4.00 10253 266,583 8.13 203.2 20832 2665 541,699
30 4.00 12475 324,339 9.43 235.6 29399 3242 764,090
35 4.00 15177 394,608 10.93 273.1 41458 3945 1,077,694
40 4.00 18465 480,100 12.67 316.7 58471 4800 1,520,024
45 4.00 22466 585,115 14.69 367.1 82482 5839 2,143,969
50 4.00 27333 710,665 17.02 425.6116272 7104 3,023,889
Investor A has the advantage of exponential growth in interest. But Investor B has several additional advantages that multiply the benefits of exponential growth compounding. When reinvesting dividends more shares of an appreciating asset are purchased versus in fixed income where a non-appreciating asset is purchased. As Investor B adds shares his stock dividends become larger and larger because of additional shares but also because he is benefiting from the increase in the dividends per share.
Interest compounding and dividend growth compounding works with any investment amount and can be multiplied many times over by making annual or regular contributions to a portfolio. Starting early greatly improves the advantages because delaying investments even for short periods of time subtracts from investment returns due to the fact benefits are back loaded.
Dividend Growth Investing combines the benefits of compounding dividends, compounding the growth in dividends per share, and the increasing value of the shares themselves. The key principle is to take advantage of the power of exponential growth by reinvesting growing dividends over long periods of time. Implementing a Dividend Growth compounding strategy can provide increasing returns and build extraordinary wealth for the patient investor.
The Arbor Asset Allocation Model Portfolio (AAAMP) maintains an asset allocation in dividend growth at all times. Re-investing dividends allows the portfolio to take advantage of dollar cost averaging and exponential compounding.
| AAAMP Blog by Ken Faulkenberry | |
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Ken Faulkenberry earned an MBA from the University of Southern California (USC) Marshall School of Business with an emphasis in investments. Ken has 25 years of investment experience and is dedicated to helping people with self-directed investment management through the Arbor Investment Planner. His asset allocation strategies have an outstanding performance record. |
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{ 1 comment… read it below or add one }
excellent post and couldn’t have illustrate better. one thing about a compounding dividends guide i wrote sometime back emphasis the difference between interest compounding and dividends compounding. i think your article is what will make my readers understand much better.