An understanding of wealth-enhancing concepts such as compound dividends is the cornerstone of a successful long-term investment strategy. The power of compounding dividends will add significant profits to your investment portfolio over time. Select investments and strategies with a eye toward the potential of growth through dividend reinvestment.
Dividends vs. Interest
The income earned from different types of investments can be broadly divided into two categories: interest and dividends. Bank accounts and bonds earn interest. With interest-paying investments, you usually know in advance the rate of interest you will earn. The investment classes of stocks, mutual funds and exchange-traded funds pay dividends. If you've invested in stocks, dividends are a portion of corporate earnings paid out to investors. If you've invested in funds, dividends are the pass-through of earnings from a fund's investment portfolio. Not all stocks or stock funds pay dividends. Future dividend amounts are less predictable than the rate from interest-paying investments.
Dividends from an investment compound when they are reinvested into more shares of the stock or fund. Dividend-paying investments make distributions either quarterly -- four times a year -- or monthly. As the number of shares grows, the amount of dividends earned increases, allowing even more shares to be purchased. Over time, the number of shares owned can grow significantly due to the growing and continually reinvested dividend stream. With a dividend reinvestment plan, you will see the growth in your investment account due to the compounding of dividends. As an example, let's say you invested $5,000 per year for 30 years in a stock at $100 per share that pays an annual dividend of 18.3 percent. After 30 years of compounding dividends, that initial investment would have grown to just under $5 million, according to TopStockAnalysts.com.
Automatic Compounding Investments
Some investment types let you set up automatic reinvestment of dividends, allowing the dividends earned to automatically compound. Mutual funds offer the choice of receiving distributions in cash or reinvesting them in more shares. Selecting the reinvestment option with a dividend-paying mutual fund is one of the best ways to increase value. Individual stock dividends can be compounded with dividend reinvestment plans offered directly by dividend-paying companies. Dividend reinvestment plans work best with stocks that have a long history of steady dividend payments.
If you own shares of dividend-paying stocks or ETFs in a brokerage account, the dividends from these investments will only be reinvested automatically if you ask the brokerage to set up your stock that way, and the company that issues the stock allows it. Otherwise, dividends going into a brokerage account are held as part of the cash balance until you do something with the money. You can use any dividends earned to manually compound the dividends by buying more shares with the earned dividends. Manual reinvestment has the advantage of allowing you to pick the specific stock and time of the reinvestment. A negative factor of manual reinvestment is the broker commissions you must pay to buy more shares with your dividends.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.