Dividend growth investing is not a get-rich-quick scheme. On the contrary, it is a long-term strategy of gradually building a sustainable and growing dividend income stream by investing in the stocks of companies that pay increasing dividends. The strategy takes advantage of the power of compounding over time, which is driven by dividend reinvestment and dividend growth.
In a previous article I illustrated how various factors affect the compounding of dividend income over a 30-year period. My hypothetical scenario involved an initial investment of $10,000, an initial dividend yield of 3.5%, a capital appreciation rate of 5%, and a dividend growth rate of 5%. At the start of each year, all dividends accumulated during the previous year were reinvested and $1,000 in new capital was invested. The portfolio was assumed to be held in a Roth IRA, so dividends were not taxed. The figure below shows the compounding effect over time, with annual dividend income increasing from $350 in Year 1 to $7,703 in Year 30.
Although an investor might be pleased with the end result of decades of compounding, he might be less satisfied during the early stages of investing, when the dividend income can be rather modest. The inset portion of the figure magnifies the annual dividend income for the first eight years, showing that it has yet to reach $1,000 by the end of Year 8. Of course, these results reflect the conditions I specified, but they may be fairly representative for young investors who are just starting out and have limited capital to invest. This raises an important question: How can investors stay committed to dividend growth investing in the early years, when dividends are small and the compounding effect is not salient? In this article I suggest some ways in which investors can appreciate the small steps of dividend growth investing while they wait for the giant leaps down the road.
Focus On Relative Changes In Dividends Over Time
As discussed in my very first article on Seeking Alpha, the yardstick I use for measuring the success of my dividend growth investing is how much my dividend income increases over time. If my dividend income grows from year to year at a rate that exceeds inflation, then that is unequivocal evidence that I am making progress toward my goal of building a rising dividend income stream.
From this perspective, what matters most is not the absolute amount of dividends, but the relative change over time. Returning to the figure above, the Year 2 dividend income of $415 does not seem like much in absolute terms. However, it represents an 18.5% increase over the Year 1 amount of $350. You would likely be happy with an 18.5% increase in your job income, so why not view the increase in dividends in the same light? I think that focusing on relative changes in dividend income can be useful for assessing the success of a dividend growth investing strategy, irrespective of the absolute dividend amounts. I contend that an investor whose annual dividend income is growing at a double-digit rate is doing quite well. That said, there are also ways in which absolute dividend amounts can be motivational, as discussed in the next section.
Set Realistic Goals And Mark Milestones
Besides tracking relative changes in dividend income, I recommend setting realistic goals and marking milestones on the way to achieving those goals. For example, at the start of this year I set the goal of receiving $1,300 in dividends in 2012. I judged this to be a realistic goal based on the existing yield of my portfolio, a projection of dividend growth, and an estimate of how much new capital I would likely invest during the year. By the end of August I was already 78% of the way toward my goal, and it looks like I will achieve it ahead of schedule. Monitoring how much closer I get to the goal each month has been motivational for me, which is why I encourage other investors to consider setting annual dividend goals.
I also find it motivational to mark milestones. Two important milestones for me are my monthly and annual dividend totals. For the monthly total, I consider every $100 increment to represent a new milestone. Back in March I reached the $100 level for the very first time (and my dividends have exceeded $100 every month thereafter). The next milestone is the $200 level, which I expect to reach early next year. For the annual total, I find it sensible to use $1,000 increments for my milestones. By August I had reached the $1,000 level for the first time and perhaps next year I will reach the $2,000 level. A convenient feature of the annual dividend milestone is that each year I can monitor how long it takes me to reach earlier milestones. For example, this year I reached $1,000 by the end of August, but next year I might be able to do it by July. Each successive year I should be able to reach the milestone sooner, which is another way of gauging my progress.
Think About What You Could Buy With Your Dividends
I recommend reinvesting all dividends if you do not need them to pay expenses because dividend reinvestment is a key factor in long-term compounding. However, it can be useful to consider what you could buy with your dividends if they were not reinvested. Small dividend amounts can be quite meaningful in certain contexts, reinforcing the notion that they represent money (not merely numbers) that could be used to pay for goods and services. I offer two approaches for putting dividends in context:
One approach is to look at which monthly expenses would be covered by dividends. For example, if your monthly dividends add up to $50, that amount might cover a utility bill or pay for a tank of gas. Alternatively, your dividends might pay for a few trips to the movie theater or nights out at the bar. If your expenses do not vary much from month to month, you can monitor the percentage of your expenses covered by dividends. Tracking how that percentage increases over time can be a good motivational tactic because once it reaches 100%, you are earning enough income from dividends alone to pay for your lifestyle.
Another approach is to consider which products you would be able to buy with your dividends from the companies paying those dividends. Here are examples of products I could buy from companies in my portfolio based on the quarterly dividend payments I actually receive from them:
- A few 12-packs of Coca-Cola beverages with the $15.30 from Coca-Cola (NYSE:KO)
- Two large bottles of Tide liquid laundry detergent with the $28.10 from Procter & Gamble (NYSE:PG)
- Four or five meals with the $35.00 from McDonald's (NYSE:MCD)
- Five cans of Spam with the $15.00 from Hormel Foods (NYSE:HRL)
When you take a moment to think about what you could buy with your dividends if they were not reinvested, you may find that even small dividends can pay for a lot of things.
Dividend growth investing is a sensible strategy for generating income, but it requires patience and commitment if you are to reap the long-term benefits of compounding. In this article I have suggested three ways in which an investor can appreciate the small dividends received in the early years of investing. Some readers might view my suggestions as psychological gimmicks, but if they help investors stay motivated and focused on achieving their investing goals, then that is all that matters.
Disclosure: I am long HRL, KO, MCD, PG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.