The Little-Known 'Eighth Wonder' That Will Increase Your Wealth 8-Fold
Everyone knows that Albert Einstein was a brilliant theoretical
physicist. Fewer know that Einstein was also a keen market
observer, having pointed out that "Compound interest is the eighth wonder
of the world. He who understands it, earns it ... he who doesn't ... pays
it."
In short, Einstein realized that compounding interest is a serious wealth
generator, especially if you reinvest the interest to let interest
compound upon interest. Over time, compounding takes on the
properties of a snowball rolling down hill - the longer it rolls, the
bigger it gets, and the more snow it accumulates.
Here's an example: You invest $5,000 in an investment that earns 6%
annually. After the first year, you earn $300 on your original
$5,000 investment. After the 35th year, you earn $2,305 on a
principal balance of $38,430. Your wealth has increased 8-fold in
the 36th year.
But there is a better strategy for turning $5,000 into $40,000 - a
strategy Einstein unlikely knew, and one few investors know to this
day. I'm speaking of coupling dividend-growth stocks - stocks that
consistently hike their dividend payouts annually - with a dividend
reinvestment plan.
I've always been a fan of dividend-growth stocks. Management's
commitment to growing the dividend presages superior financial
performance over time. Ned Davis Research analyzed returns on
S&P 500 stocks from 1972 through 2010 and found that stocks that grew
and initiated dividends provided superior returns than all other stock
classes.
Just as impressive, the superior returns dividend-growth stocks generate
are not encumbered with more risk. To the contrary, dividend
growers posted greater return with less risk (measured as standard
deviation of returns, a common financial measure). It turns out
that there really is a free lunch.
What you do with this growing stream of dividends is key to accumulating
wealth. You can receive your dividends and spend them, you can
divert them to another investment, or you can buy more of the stock that
generated the dividend.
The best course is to plow the
dividends back into the original stock. You are not only investing in the
proven dividend grower but you are also relieving yourself of
reinvestment risk - the risk of finding investments as good as the
company that generated the dividend. You are also dollar-cost
averaging, which means you buy more shares on price pullbacks and fewer
shares near market tops.
Most importantly, you capture the benefit of Einstein's eighth wonder -
compounding on both your initial principal investment and the dividends
you receive. What's more, you are compounding a rising stream of
income, not a fixed stream prevalent on a typical savings account or debt
investment.
Our High Yield
Wealth portfolio features a number of high-quality, proven
dividend-growth stocks that offer dividend-reinvestment plans (known by
the acronym DRIP). These plans allow you to automatically reinvest
your dividends in the company's stock. Once you are enrolled (and
enrolling is easy), your work is done and the wonders of compounding take
over.
Below is a chart I created for one of the High Yield Wealth
dividend-growth stocks. McCormick & Co. (NYSE:
MKC) is the company, and
McCormick offers a DRIP (here's
the link).
I didn't choose McCormick because of extraordinary growth. In fact,
McCormick's growth isn't spectacular; it's simply steady and
reliable. McCormick's revenue and earnings generally increase at a
mid-to-high, single-digit rate year over year. Over the past 16
years, the dividend has grown at an average annual rate of 9.6%.
The graph below shows what would have happened had you invested $5,000 in
McCormick in January 1995. The average split-adjusted price at the time
was $9 per share, which means you could have purchased 555 shares
(rounding down to the nearest integer) with your initial
investment. The dividend that year was $0.265 per share. Total
dividend income for the year: $147.
By 2011, McCormick's dividend stream had swelled to $1.15 per
share. Because dividends were reinvested in McCormick shares, the
number of McCormick's shares owned increased to 790 shares. Total
dividend income for the year: $909.
The snowball effect is the most important take away from the above
graph. After six years your $5,000 investment would have doubled in
value; after seven years it would have nearly tripled; and after 10 years
your investment would have increased five-fold. The dividend-growth
strategy turned $5,000 into $40,000 in less than 17 years. The
fixed-income compounding example I noted at the beginning took twice as
long.
The eighth wonder of the world isn't compounding interest; it's
compounding dividend-growth stocks. That's why this year I intend
to introduce High Yield
Wealth subscribers to not only more proven dividend growers but
also to new dividend payers that show promise of blossoming into "Eighth
Wonder" dividend growers.
Stephen Mauzy, CFA
Research Analyst
High Yield Wealth
