Every investor should be aware of the miracle of compounding. It’s especially important for anyone seeking long-term growth.
Everything you invest in should provide the option to reinvest dividends. Most stocks, but not all ETFs, give you that chance. Here’s how it works and why it’s so beneficial.
Say you buy a stock or ETF or mutual fund that pays a three percent dividend — more if it’s a fund that distributes capital gains or returns of capital. But let’s use 4 percent. You buy 100 shares at $10. During the year it pays 40 cents a share — $40 — in dividends. To simplify, let’s assume the stock stays at $10. If the dividends were reinvested, at the end of one year you’d have 104 shares. The second year’s dividend is now paid on 104 shares, so you’d receive $41.60, which if reinvested, brings your investment to 108.16 shares. In the third year you’d receive $43.26; raising your total shares to about 112.49.
Extend the math out 20 or 30 years and you’ll be astounded at the difference it can make.
Of course, the increase in your number of shares will vary, depending on the price fluctuations of the stock. It’s actually to your benefit if the stock price is lower during these years, as that enables your reinvested dividends to buy more shares. Being happy about your stock price declining along the way requires a long-term view, but it’s more profitable than if it does nothing but go up from the day you buy it.
The important thing is to always choose the option of reinvesting dividends — which any brokerage firm will show on its website. And avoid those ETFs or funds that do not allow it.
Another way to let compounding work for you is to raise the amount you save and invest by whatever percentage you’re comfortable with and can afford. Successful young retirement planners put aside the first money they make each month or year rather than what’s left over at the end of the month or year. It’s called “paying yourself first.”
The same principle works for income investors who do not need the immediate cash payout. It’s a way to see your dividend income increase each year until the time when you need to receive the income. The change from one status to another is an easy checkmark on your broker’s website.
You cannot automatically reinvest interest payments on CDs or bonds. If you are nearing retirement and have say, a 60-40 or 50-50 balance of stocks and CDs (I wouldn’t suggest holding bonds, which are not as safe and yield less than FDIC-insured CDs), the only way to reinvest interest payments is to buy another CD with the interest you’ve received if it’s enough. You may have to wait until it adds up to at least $1,000 to do so.