I've often said that reinvesting dividends is one of the keys to building wealth, and today – because I like to walk the talk – I'll be reinvesting some of the "cash" in my Strategy Lab model dividend portfolio.
But first, let's look at why reinvesting is so important to long-term returns.
Consider two investors, whom we'll call Harry and Sally (my age is showing, I know).
On Dec. 31, 1993, each invests $10,000 in shares of Royal Bank of Canada. They hold their shares for the next 20 years, the only difference being that Harry spends his dividends while Sally reinvests the quarterly payments in additional shares of Royal Bank.
Now, it's obvious that Sally will come out ahead. After all, she's not spending her dividends like Harry is. But the magnitude of the difference may surprise you.
At the end of 20 years – on Dec. 31, 2013 – Harry's $10,000 investment will have grown to $98,923, according to Bloomberg calculations. That sounds impressive, until you compare it to Sally's investment. It will be worth $193,301 – nearly twice as much as Harry's. On an annualized basis, their returns work out to 12.1 per cent and 15.9 per cent, respectively.
Why is Sally so much further ahead? Not spending her dividends is certainly a factor, but it's what she does with those dividends that really turbocharges her wealth. Every new share she purchases produces additional capital gains as Royal Bank's stock price rises. What's more, each new share spins out even more dividends, which in turn purchase additional shares. And so on.
It's a virtuous circle, and, given enough time, compounding can produce stunning results.
Another key thing to note here is that Royal Bank's dividend has also grown dramatically. Back in 1993, it was paying 7.25 cents quarterly (adjusted for stock splits). Now, it is shelling out 71 cents – nearly 10 times as much. Twenty years ago, Sally would have been receiving about $400 in dividends annually on her initial $10,000 investment; now, because she owns more shares and each share is paying a significantly higher dividend, her annual dividend income alone would be about $7,500.
Some caveats are in order. These examples ignore the impact of taxes and commissions, and they assume that every penny of dividends is reinvested in additional shares (which you can do with a "true" dividend reinvestment plan operated by a company's transfer agent, but not with a "synthetic" DRIP operated by your broker).
There are various ways to reinvest – you can enroll in a DRIP, buy a low-cost fund that automatically reinvests distributions for you or accumulate cash until you decide to pull the trigger on a purchase every few months or so.
I prefer the third method, both in my personal accounts and my Strategy Lab portfolio, because it gives me more control over the process. Which brings us to the second part of today's column.
As of April 30, I had $737.92 in cash sitting in my Strategy Lab model account. I've decided to use that money to purchase 10 additional shares of … you guessed it, Royal Bank. That will give me a total of 90 Royal Bank shares and – based on Tuesday's closing price of $73.40 – eat up all but $3.92 of my cash balance. (Disclosure: I also own Royal Bank in my personal portfolio).
I like Canadian banks for several reasons. They make obscene amounts of money. They have their tentacles in every corner of our economy. And they don't face a lot of outside competition. What's more, they're well-diversified, with corporate and personal lending, wealth management, investment banking and insurance operations all contributing to the bottom line.
And, of course, they pay attractive dividends that rise over time. Like Sally, I intend to reinvest those dividends to maximize my returns.