Dividend growth investing is an investment strategy that has many key advantages, whether you’re in the process of building a long-term portfolio or living off a dividend stream. Here’s a closer look at why dividend growth investing works for so many investors.
Compounding – the secret to building long-term wealth
It’s no secret that ‘compounding’ is the most powerful tool when it comes to building long-term wealth. Compounding is the process of generating earnings on an asset’s previous reinvested earnings, and over time, results in the exponential growth of an investor’s capital. Ask Warren Buffett about the importance of compounding and he’ll explain that it’s one of the largest factors behind his success as an investor.
That’s why dividends are important when building a long-term portfolio, as dividends provide the investor with the opportunity to compound on a regular basis. However, in a dividend growth investment strategy, the compounding benefits are essentially magnified, because the stream of dividends to be reinvested grows year after year. The results, over the long term, can be powerful.
Furthermore, the strategy is capable of generating significant capital growth over the long term, on top of a rising stream of dividends. That’s because rising dividend payouts, over time, lead to rising share prices. As a company increases its dividend payout year by year, demand for the stock should increase, and its share price should rise. The result is the winning combination of both dividend and capital growth, a combination that can really propel portfolio returns exponentially higher over the long term.
Less volatility and more peace of mind
The strategy also provides comfort during bear markets and periods of high volatility. Companies that consistently increase their dividends are generally mature, stable companies and these companies are often less volatile than growth and speculative stocks during bear markets.
Furthermore, knowing that your portfolio will continue to pay a strong dividend stream irrespective of market sentiment, provides great comfort during periods of market panic and can really assist investors in sticking to their long-term investment strategies when volatility arises.
Dividend growth investing can also work well for those looking to generate an income in retirement, as dividend growth stocks can literally become cash cows over the long term.
Consider a company that pays a 4.5% dividend, growing at 7% per year. If an investor holds this company for 15 years, the dividend yield will increase to a huge 12.4% yield on the original purchase price. Financial experts often advise that shares as an asset class will generate around 8-10% per year, however, with dividend growth stocks it’s possible to achieve this kind of return from yield alone if you’re patient enough.
Lastly, in contrast to bonds, in which coupons are generally ‘fixed’, the dividend growth investor’s income stream is always increasing. This means that, unlike the bond investor who is constantly losing purchasing power to inflation, the dividend growth investor’s income stream should grow faster than inflation. For those looking to live off a stream of dividends, this is a huge benefit.
This article is provided for general information only and is not intended to be investment advice. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.