(Published Jan. 26 by The Financial Canadian)
The main goal of a dividend growth investor is to provide a passive income stream that increases over time.
With a high savings rate, robust investment returns and a long enough time horizon, this will lead to surprising wealth in the long run.
For many investors who are just starting out, this may seem like an unrealistic pipe dream.
After all, the S&P 500 dividend yield is currently 2.0%. This does not seem like a high enough rate to really make someone rich.
Despite this, dividend growth investing remains one of the most straightforward, repeatable ways to become rich.
This article will show that investors really can get rich from dividends.
The parameters in question
Before showing you how an investor can become rich from dividends, first I would like to define the term "rich."
While many have pegged an arbitrary net worth number as the cutoff for being rich, I believe this is not realistic. Wealth is relative. As such, we will consider someone to be "rich" if they generate enough passive income to cease working for money’s sake alone.
Rich people often continue to work because they enjoy it. The distinction is that they do not need to.
Going back to the question in the title, the answer is yes. Investors can become rich from dividends. The method is simple (though the execution may not be):
- Save money (the more, the better) from your employment by spending less than you earn.
- Develop a long-term systematic investing plan and follow it.
- Reinvest all dividends (perhaps using a DRIP).
- Eventually, your portfolio will grow large enough to cease working for money’s sake.
There are three main factors that lead to overall investment success. These were all included in the four-step plan outlined above. These factors are:
- Time Horizon
- Savings Rate
- Investment Returns
Some of these factors are more malleable than others. For most people, it is more difficult to double investment performance than it is to double your savings rate. I want to provide a few benchmarks for my assertions that a metric is "low" or "high." Consider the following:
- The average savings rate in the U.S. is roughly 5%
- The S&P 500 has returned ~9% annualized on a long-term basis.
For simplicity’s sake, I will be assuming investors have a 100% allocation to equity securities. I will also be assuming each investor’s net income is $60,000. Further, the assumed retirement age will be 65.
Without further ado, here are three examples of how an investor can really get rich from dividends.
Example No. 1: High savings rate, average investment returns, short time horizon
Investor no. 1 receives an annual income of $60 thousand net of taxes and has a savings rate of 15%, which is three times as high as the average. This allows them to invest $9 thousand annually.
However, the investor only begins to invest in the stock market at the age of forty, giving them a 25-year time horizon for their investments if they intend to retire at the age of 65.
The following table outlines the trajectory of this person’s investment portfolio over time.
At age 65, the investor will have a common stock portfolio of nearly $850 thousand, which generates income of approximately $16,800 completely passively with a portfolio dividend yield of 2% (very attainable). The investor can withdraw more if they are willing to reduce the capital base of their portfolio.
Example No. 2: Low savings rate, average investment returns, long time horizon
Investor no. 2 receives an annual income of $60 thousand net of taxes and has a savings rate of 2.5%, which is half as high as the average. This allows them to save $1,500 per year to invest in stocks.
Despite their low savings rate, this investor understood the power of compound interest from a young age and began investing in high-quality dividend stocks immediately upon entering the workforce at age 22.
The following table outlines the trajectory of this person’s investment portfolio over time.
This investor’s extremely long time horizon helps to compensate for their low savings rate, leaving them with a retirement nest egg almost as large as investor no. 1. Their final portfolio value of approximately $722 thousand will generate passive income of $14.4 thousand annually from a very reasonable 2% portfolio dividend yield.
The most striking thing about this example is the vast difference between the investor's total contributions ($66 thousand) and their final portfolio value ($722 thousand). This is due to the investor’s extremely long time horizon.
Think about that for a second. Invest $66 thousand – and it eventually becomes approximately $722 thousand, more than 10 times the initial investment. That is the power of compounding in action.
Example No. 3: High savings rate, average investment returns, long time horizon
This individual begins their career at age 22 by putting 15% (or $9 thousand) of each year’s pay into a portfolio of high-quality dividend stocks. Given that they started investing at the beginning of their career, they also benefit from a long time horizon, with 43 years between their initial investment and their retirement age of 65.
The following table outlines the trajectory of this person’s investment portfolio over time.
Upon retirement at age 65, this investor has a $4.3 million nest egg. Even if their portfolio is composed entirely of low-yield dividend stocks that yield 2%, they are still generating more than $80 thousand of dividend income per year – more than the salary at their previous day job.
This proves an investor can become rich on dividends. Investing in high-quality dividend growth stocks with yields of around 3% would create a portfolio with annual dividend income over $100 thousand;Â not a bad retirement at all – especially considering this income is very likely to continue rising with high-quality dividend growth stocks.
Final thoughts
While this analysis may seem detailed, it is actually oversimplified in a number of ways. For brevity’s sake, many important factors about investing were not addressed. These include:
- The effect of taxes and fees on portfolio performance.
- The upwards wage trajectory that most people experience during their careers.
- The effect of inflation on the real value of a dollar.
- The volatility of the stock market – each analysis here assumed smooth returns.
- The ability to potentially increase investment returns using a system like The 8 Rules of Dividend Investing.
This analysis sought to emphasize the importance of two factors: savings rate and time horizon. Savings rate affects how much we have to invest; time horizon affects how long we have to invest.
Of the two, I believe we have the most control over our time horizon. I also believe it has a greater effect on investment performance than our savings rate. Consider the following diagram for evidence of this.
I am not the only one who believes in the importance of a long time horizon. Seth Klarman (Trades, Portfolio), the billionaire founder of the Baupost Group hedge fund, said:
“The single greatest edge an investor can have is a long-term orientation.”
As long as an investor maintains strict discipline over their time horizon and savings rate, then it is highly possible to become rich from dividends.
Disclosure: I am not long any of the stocks mentioned in this article.
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