When Should I Transition From Capital Gain Investing To Dividend Growth Investing?
I saw a comment recently from a young investor who said, "I will use a capital gain strategy from now until I retire, then I will switch to a dividend growth strategy." I wondered, "When is the optimal time to make that switch?" My hunch was that the earlier one begins dividend growth investing, the more time compounding has to work its magic, but I wanted a more quantitative answer to the question, so I wrote this article.
I will present three scenarios here. In all three, let's agree to ignore complications like taxes, fees, commissions, inflation, the time value of money, etc., just to simplify the presentation. Let's assume all dividends are paid once per year. Imagine everything you read below is prefaced with the phrase, "All other things being equal …" (which of course, they never are).
In scenario 1, you use a capital gain strategy for 30 years, then you switch to a dividend growth strategy. You spend $1,000.00 to buy shares of company XXX. XXX does not pay a dividend. XXX's shares go up in price by 10% per year. After 30 years, your shares are worth $17,449.40. You sell all of your shares. You spend that $17,449.40 to buy shares of company YYY. YYY pays a dividend of 3%, and raises its dividend by 10% per year. YYY's shares never change in price. You receive $523.48 in income during year 31. Your total return after 31 years is $17,449.40 + $523.48 or $17,972.88.
Here is a spreadsheet detailing scenario 1:
Scenario 1

In scenario 2, you use a dividend growth strategy for 30 years, but you do not reinvest dividends. You spend $1,000.00 to buy shares of company YYY. YYY pays a dividend of 3%, and raises its dividend by 10% per year. YYY's shares never change in price. You receive $523.48 in income during year 31. Your total return after 31 years is $1,000.00 + $5,458.30 or $6,458.30.
Here is a spreadsheet detailing scenario 2:
Scenario 2

Let's compare the two scenarios. After 30 years, in scenario 1, you have shares worth $17,449.40, and next year's income of $523.48; in scenario 2, you have shares worth $1,000.00, a cash balance of $4,934.82, and next year's income of $523.48.
From a total return perspective, it looks like scenario 1 is better ($17,972.88 is more than $6,458.30).
I think the more interesting question is: why is the next year's income the same in both scenarios? It can't be a coincidence.
It isn't.
In scenario 1, your share price grows by 10% per year. You begin with $1,000.00.
After year 1, you have $1,000.00 * 1.1.
After year 2, you have $1,000.00 * 1.1 * 1.1.
After year 3, you have $1,000.00 * 1.1 * 1.1 * 1.1.
After year 30, you have $1,000.00 * 1.1 * 1.1 * 1.1 * … * 1.1 (repeated 30 times).
Your first year of income is $1,000.00 * 1.1 * 1.1 * 1.1 * … * 1.1 (repeated 30 times) * 3%.
In scenario 2, your dividend rate grows by 10% per year. You begin with 3%.
After year 1, you have 3% * 1.1.
After year 2, you have 3% * 1.1 * 1.1.
After year 3, you have 3% * 1.1 * 1.1 * 1.1.
After year 30, you have 3% * 1.1 * 1.1 * 1.1 * … * 1.1 (repeated 30 times).
Your first year of income is 3% * 1.1 * 1.1 * 1.1 * … * 1.1 (repeated 30 times) * $1,000.00.
Note how it doesn't matter if the price grows by 10%, or if the dividend grows by 10%; you end up with the same formula, hence the same next year's income.
In scenario 3, you use a dividend growth strategy for 30 years, but you do reinvest dividends (for 30 years, then you consume the dividends). You spend $1,000.00 to buy shares of company YYY. YYY pays a dividend of 3%, and raises its dividend by 10% per year. YYY's shares never change in price. You receive $42,557.07 in income during year 31. Your total return after 31 years is $81,296.14 + $42,557.07 or $123,853.21.
Here is a spreadsheet detailing scenario 3:
Scenario 3

Why are the numbers in scenario 3 so much larger? Because when you reinvest rising dividends, you get two layers of compounding: (1) each share pays you a higher and higher dividend, and (2) reinvesting dividends means you have more and more shares, each of which pays you a higher and higher dividend. Some SA authors have called this "double compounding" or "hypercompounding."
Let's compare the three scenarios:
In scenario 1, your year 31 income is $523.48. Total return is $17,972.88.
In scenario 2, your year 31 income is $523.48. Total return is $6,981.78.
In scenario 3, your year 31 income is $42,557.07. Total return is $123,853.21.
From an annual income perspective, scenario 3 beats the other two by year 19.
From a total return perspective, scenario 3 beats the other two by year 26.
Conclusion
I know what you're going to tell me  no company has ever raised its dividend by 10% per year for 30 consecutive years. That's true. (But look at my dividend web site to see which companies have raised their dividends by X% for Y consecutive years.) It's also true that no company has ever raised its price by 10% per year for 30 consecutive years.
However, my point is that the earlier you begin the compounding of dividend growth companies, the more income you will end up with.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.