In my last post I explained the basic principle of what a dividend is and how it plays a part in investing. This next post covers compounding or compound interest and how it plays a huge part in any dividend investment strategy.
I never really paid much attention to compounding interest before. I knew I was paid interest in my bank account every month, and the whopping 25 cents was added to my balance. It wasn’t until I started researching to be a self investor that I truly learned the power of compounding. It’s a highly efficient, money making machine that turns small amounts of money into a large pile of money over a period of time. When you invest in dividend paying stock, your dividend payments are like an interest payment from the bank, except it comes from the company you invested in. The money is deposited into your trading account and like interest, you can spend it OR you can re-invest the dividends to by more stock which in turn, will pay you more dividends in the future.
Let’s say you bought 100 shares of BCE on Jan 29, 2010. The cost of one share would have been $27.71 and the dividend at the time was $1.62 a share, which would yield a return of 5.84%. So you would be paid $162 for an investment of $2771. If you were to re-invest the dividend and buy more shares (for simplicity sake, we will say the stock price stayed the same with no dividend increases) the following year, you would be able to buy 5 more full shares and your dividend payment would be $170. After 10 years it would look something like this:
Consider two individuals, we’ll name them Pam and Sam. Both Pam and Sam are the same age. When Pam was 25 she invested $15,000 at an interest rate of 5.5%. For simplicity, let’s assume the interest rate was compounded annually. By the time Pam reaches 50, she will have $57,200.89 ($15,000 x [1.055^25]) in her bank account.
Pam’s friend, Sam, did not start investing until he reached age 35. At that time, he invested $15,000 at the same interest rate of 5.5% compounded annually. By the time Sam reaches age 50, he will have $33,487.15 ($15,000 x [1.055^15]) in his bank account.
What happened? Both Pam and Sam are 50 years old, but Pam has $23,713.74 ($57,200.89 – $33,487.15) more in her savings account than Sam, even though he invested the same amount of money! By giving her investment more time to grow, Pam earned a total of $42,200.89 in interest and Sam earned only $18,487.15.