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Young investors are often told they should take on more risk than older investors and pursue high-growth investment opportunities. The rationale behind such advice is threefold. First, there is the potential for massive gains from stocks that rapidly increase in value. If you are successful at what Peter Lynch calls stalking the tenbaggers (stocks that experience tenfold price increases), then you can get rich quickly. Second, even if you are unsuccessful, it is argued that you have plenty of time to make up for large losses from investments that did not pan out. Third, given that many young investors have jobs that provide them with sufficient income, it is sometimes argued that there is not much point in focusing on slower-growing dividend-paying stocks because the dividend income is not needed at this time in their lives.

I disagree with this approach. I do not think young investors need to aggressively pursue high-growth stocks. I do not think they need to risk the large losses that can potentially arise from such a pursuit. I do not think they should brush off dividend-paying stocks simply because they have no immediate need for dividends.

My alternative view is that dividend growth investing is a sensible strategy for young and old investors alike. The strategy involves buying the stocks of companies that not only pay dividends, but consistently grow them every year. Examples of such stocks include Chevron (NYSE:CVX), Coca-Cola (NYSE:KO), Johnson & Johnson (NYSE:JNJ), McDonald's (NYSE:MCD), and Procter & Gamble (NYSE:PG), all of which have increased their dividends for at least 25 consecutive years.

Older investors may need dividends to replace or supplement their income during retirement, which is a likely reason why many of them are attracted to dividend growth investing. Young investors who do not need to use their dividends can fully reinvest them to facilitate compounding of the dividend income stream over time. Compounding occurs when dividends are reinvested to produce more dividends - using the money that money makes to make more money. It is a powerful force for building long-term wealth, but it takes time for that power to manifest itself in a noticeable way. For this reason, young investors may not appreciate why dividend growth investing is a sensible strategy for them.

A Simple Illustration Of Compounding

I did not fully appreciate the power of compounding until I started crunching numbers and looking at graphs of how it worked. In a previous article I examined how the compounding of dividend income is affected by factors such as dividend reinvestment, dividend growth, capital appreciation, investment of new capital, taxes, and time. It is worthwhile revisiting my baseline scenario, where I assumed the following:

  • Initial investment of $10,000
  • Dividend yield of 3.5%
  • Dividend growth rate of 5%
  • Stock price appreciation rate of 5%
  • Full dividend reinvestment at the end of each year
  • Investment of $1,000 in new capital at the end of each year
  • Portfolio held in a Roth IRA, so no taxation of dividends or capital gains

Given these conditions, Figure 1 shows how dividend income increases over 30 years:

Compounding is reflected by the nonlinear growth in dividend income, with a mere $350 in dividends in Year 1 becoming $7,703 in Year 30. On the figure I have marked when each $1,000 increment in dividends occurs. It takes 11 years until the $1,350 mark is passed in Year 12, but only 5 more years until the $2,350 mark is passed in Year 17. Once you reach Year 24, a $1,000 increment occurs every 2 years. By Year 35 (not shown), annual dividend income increases by more than $1,000 every single year.

The progressive shortening in how long it takes to boost dividend income by a given amount is a hallmark of long-term compounding. It is important to recognize that the key factor here is time. For example, after 20 years of compounding, annual dividend income is $3,177. An extra 5 years increases it by over 50% to $4,985. Keep going another 5 years and it reaches $7,703, which is more than 50% higher than the Year 25 total. In the steepest part of the growth curve, each additional year becomes increasingly important. This is why it is a good idea for dividend growth investors to start early, when they are young and can take advantage of the time available for compounding.

Comparisons With Early Aggressive Growth Investing

Figure 1 showed the potential outcome of a dividend growth investing strategy played out over 30 years, which could reflect an investor who starts investing at 30 years old and wants to retire when he is 60. However, what if our 30-year-old investor was persuaded to pursue an aggressive growth investing strategy, selecting non-dividend-paying, high-growth stocks with the hope of achieving above-average returns. Examples of such stocks (taken from the "Young and Restless" portfolio by Regarded Solutions, which is tailored to the younger, aggressive investor) include Amazon.com (NASDAQ:AMZN), Facebook (NASDAQ:FB), Google (NASDAQ:GOOG), and Zynga (NASDAQ:ZNGA).

Let us assume our young aggressive investor followed such a strategy for 10 years, then switched to dividend growth investing for the remaining 20 years in preparation for retirement. More specifically, after Year 10, all aggressive growth stocks were sold (with no tax consequences because everything was in a Roth IRA) and a new portfolio of dividend growth stocks was established, based on the same assumptions outlined earlier (except the "initial investment" is now the cash from the sell-off). Figure 2 shows some possible outcomes:

The green line labeled "DG" is our original dividend growth investor; the results are the same as in Figure 1, just expressed on a different scale for visual comparison purposes. The blue line labeled "AG-S" is an aggressive growth investor who was successful: Through a combination of skill and luck, he managed an annualized return of 17% over the first 10 years, which is double the total return of the original dividend growth investor (5% stock price appreciation + 3.5% dividend yield = 8.5% total return) and much better than historical market averages. He turned his $20,000 investment ($10,000 initial investment + 10 x $1,000 investments of new capital each year) into a little over $70,000, more than tripling his money. When that $70,000 was reinvested in dividend growth stocks in Year 11, it enabled him to receive more dividends than the original dividend growth investor, increasing to a difference of 71% in Year 30.

The comparison strongly favors the early aggressive growth strategy, but it hinges on the critical assumption of achieving a 17% annual return over 10 years. That is a very good rate of return, putting our investor in the same ranks as limited partnerships run by Walter Schloss (16.1%); Tweedy, Browne (16.0%); Warren Buffett (23.8%); Bill Ruane (17.2% for the Sequoia Fund); and Charlie Munger (13.7%). These are some of the "Superinvestors of Graham-and-Doddsville" that Warren Buffett cited in a famous 1984 article, from which the numbers were taken. Is our young and relatively inexperienced investor likely to be as good as those investors? Probably not.

Suppose that, instead of a 17% return, our aggressive growth investor achieved a more realistic 8.5% return. In that case, his dividend income from Year 11 onward would match that of our original dividend growth investor in Figure 2, so the 10 years of aggressive, high-risk investing produced no advantage. If anything, the original dividend growth investor has an advantage because he did not have to change his investing strategy.

It is possible that our young aggressive growth investor might take on too much risk and not achieve the expected high returns. The purple line labeled "AG-BE" is for an investor who breaks even after 10 years, ending up with the $20,000 he contributed during that time. Not surprisingly, he starts and finishes at lower points than our original dividend growth investor, receiving 37% less dividend income in Year 30.

What if our young aggressive growth investor actually loses money over time? If he speculates in overvalued stocks for which high growth does not materialize, then he could very easily and quickly incur sizable losses. The red line labeled "AG-L" is for an investor with an annualized return of negative 10% after 10 years, ending up with a little under $10,000 - half of the capital he invested. His dividend income in Year 30 is 59% lower than that of our original dividend growth investor.

Some readers might say that the last two comparisons are unfair because I have allowed either no gain or large losses for the aggressive growth investors, but not for the original dividend growth investor. However, bear in mind that what the figures show is dividend income, not capital gains or total return. The dividend growth investor could still achieve steady compounding of dividend income in the context of no stock price appreciation or even (unrealized) capital losses. In fact, I showed in a previous article that a flat or bear market can actually be beneficial for dividend growth investing.

Conclusion

Young investors need not follow the conventional advice of aggressively pursuing high-growth stocks, taking on excessive risk with the goal of achieving above-average returns. The desired returns might not materialize and the risks taken in pursuit of them could result in poor investing outcomes. Even though young investors may have time to recoup any capital losses, they may not be able to avoid the consequences of lost time for compounding. However, if they educate themselves about dividend growth investing, then they might just find that it is a sensible long-term strategy that could suit them well during their early and later years of investing.

Hat tip to David Van Knapp for a recent article that led to a spirited comment stream that motivated this article. Note that my reference to stocks in the "Young and Restless" portfolio by Regarded Solutions was solely for example purposes and is not meant as an expression of any opinion on either the individual stocks cited or the portfolio.

Source: Dividend Growth Investing: A Strategy For Young Investors, Too