Many investors overlook the importance of dividends when investing in shares. In an attempt to build wealth quickly, they focus on generating quick capital gains, and often take excessive risks in the process.
However dividends play a vital role in building long-term wealth through the share market. Indeed, some studies have shown that in the long run, dividends, when reinvested, can account for up to 80% of total investment returns.
Dividend growth investing is a particular style of dividend investing that focuses on not only investing in companies that pay dividends, but investing in companies that consistently increase their dividend payouts over time. This investment strategy has many key benefits and can suit a broad range of investors, from those starting out to those in retirement.
Here’s a look at some of the advantages of a dividend growth investment strategy.
The power of compounding
Ask any financial expert about the secret to building long-term wealth, and it’s highly likely that they’ll mention the word ‘compounding’. 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. Warren Buffett has stressed the importance of compounding in the past and Albert Einstein even referred to it as the ‘8th wonder of the world.’
This is where dividends play a fundamental wealth creation role, as when they are reinvested to purchase more securities, the investor is able to effortlessly capitalise on the power of compounding. And because the dividends received grow every year in a dividend growth strategy, the exponential gains are multiplied, resulting in powerful returns over the long term.
Increasing income stream
Another key benefit of dividend growth investing is that the investor’s dividend income should grow at a pace that is higher than inflation. Given that many retirees rely on dividends for income in retirement, this is a huge plus.
In contrast to bonds, which generally pay a ‘fixed’ coupon to investors on an annual or semi-annual basis, it’s possible to find companies that increase their dividend payouts by 5-10% per year. While a bond coupon will be worth less and less as inflation rises over time, the dividend growth investor’s income should rise faster than inflation, meaning that the investor does not need to be concerned about losing purchasing power.
Furthermore, when held onto for the long term, dividend growth stocks can transform into powerful cash-generating machines. Consider a company that pays a 4.5% dividend, growing at 6% per year. If an investor holds this company for 15 years, the dividend yield will increase to a formidable 10.8% yield on the original purchase price.
But it’s not just increasing dividends that the investor will benefit from with a dividend growth strategy – capital growth can also be prolific.
This is because that as a company increases its dividend payout over time, the stock is likely to become more attractive as a result of the higher yield. More investors will be attracted to the higher yield and this in theory should result in an increase in the share price.
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.
Lastly, companies that consistently increase their dividends are generally mature, stable companies and these companies are often less volatile than more speculative stocks during bear markets and periods of market volatility. Knowing that a company will continue to pay a strong dividend provides great comfort during moments of market panic and can assist investors in sticking to their long-term investment strategies.