Last Updated on December 22, 2020 by Oddmund Groette
The entire point of investing in dividend-paying stocks is to aim for an extra source of income that promises to increase with time. It has been proved with the help of years worth of data that a steady savings rate, strong investment returns, and a long time horizon can lead to exceptionally hefty wealth in the long run. So yes, you can get rich via dividend investing.
It’s quite understandable for investors who are just starting out, to have a pessimistic take regarding the long-term benefits of dividend stocks. And yes if they check the dividend yield of the S&P 500, it is currently at a paltry 1.62%, and think it’s not high enough to make someone that rich. But dividend yield is not the only contributing factor, in fact, it tells very little about the company and the markets.
Despite a low yield, growing through dividend investing has been one of the most efficient and effective ways to become rich for decades. Dividend stocks have proved to outperform the market for many decades. However, dividend stocks also have negatives. To learn more about dividend investing, please check our dedicated page:
There are mainly four factors that pave the way to making your investments a success. The following factors can have a drastic effect while influencing an investment’s long-term return.
Time horizon, in financial terms also known as investment horizon, is the total amount of time an investor plans to hold a security or a portfolio. Time horizon can vary anywhere from short term, a couple of days or slightly longer, or extra long term, perhaps even carried across decades. For instance, a young investor, who is just starting, could probably span his investment horizon to decades.
On the other hand, some trading strategies can only stretch investment horizons up to just days, hours, or maybe even minutes. The timeline of a time horizon can often reflect on the amount of risk an investor is exposed to and their income needs. Thus, a portfolio with a shorter time horizon can conclude to an investor’s unwillingness to take risks. Establishing an investment horizon is one of the most crucial parts of creating an investment portfolio. However, as can be shown in the examples below, the risk of not being invested for the long-term might be huge if we measure potential foregone wealth.
The savings rate is defined as a ratio or percentage that measures an amount of money out of an investor’s personal income that is set aside as a safety net or egg for retirement. In financial terms, savings is a matter of choice that reduces current expenditure in favor of future consumption. So it’s more like a time preference for spending money.
The money saved and collected can be put to better use for higher returns in the future, for example in investments like mutual funds, stocks, bonds, etc. There are several factors like, economical conditions, individual character traits, etc. that can have quite an influence on the savings rate. To save is delaying gratification to the future, something which is hard for many to do:
Returns, commonly known as the financial return, refers to the money gained or lost on an investment over a particular amount of time. The term can also be expressed as a change in currency value that is invested over a certain period of time. A ratio can be constructed from the profit gained over an investment.
Positive returns as it sounds refers to profit while a negative return represents a loss. When talking about stocks, total returns are inclusive of any price changes along with dividends and interest payments. However, be wary of the effect of inflation. You need to measure in real terms, deducted for the ongoing inflation rate. The inflation rate has been falling for about 40 years, and thus many investors are unknown of the devastating effects inflation can have on the portfolio. For example, the 1970s proved to be a lost decade in terms of real returns.
This last one is probably the least important. Multiple expansion is simply the multiplier you paid for the earnings of the company or the market. If we assume the S&P 500 trades at a trailing P/E (price/earnings) of 20, it means you are paying 20 times the annual earnings. If the earnings are five dollars a year, you pay 100 for those earnings (5 times 20). When you sell your funds or stocks in for example 15 years the P/E levels might be higher or lower depending on a variety of factors. If the earnings have shown a moderate growth to only seven after 15 years, while the P/E level has increased to 21, the price you get is 147 (7 times 21).
When the P/E levels expand, it’s called multiple expansion. The inverse is called multiple contraction. Contraction obviously leads to lower returns. If the P/E level drops to 15 in the above example, while earnings after 15 years are seven, then you only get 105 for your holdings (7 times 15). This shows how expansion/contraction influences your return.
However, if you have managed to invest in a company with a great return on capital you can afford to pay a high current earnings multiple:
With the clarity in the above three factors, the following scenarios play with these factors while increasing and decreasing them in different ways to reflect investment success.
We have made the calculations below available for your convenience at this link.
Investor 1 earns an annual income of 50 000 with a savings rate of 10%. This is actually a higher than average savings rate which allows investor 1 to invest 5 000 on an annual basis at year’s end. But the age of the investor is 40 when he starts investing in the stock market, which gives him 25 years of the time horizon to invest considering they expect to retire at the age of 65.
Assuming 7.5% annual returns, the trajectory of this investor’s regular investment for 25 years of 5 000 brings his final portfolio value to 370 000, generating a passive income of nearly 6 000 if the dividend yield is still a paltry 1.62% 25 years into the future. However, assuming dividend growth along the way, his passive income should be higher. This is a pretty conservative estimation that should have a huge margin of safety.
Investor 2 here earns an annual income of 50 000 with a savings rate of 5%, which is quite low as compared to the previous investor. With this savings rate that low, investor 2 is able to invest 2 500 per year in stocks. However, this investor is quite young with a great understanding of compounding and starts investing in the stock market at the early age of 25 that gives him 40 years of the time horizon.
The longer than average time horizon, investor 2, despite its low savings rate, is able to build a portfolio value of approximately 613 000 while successfully acquiring a passive income of almost 10 000 if the dividend yield is still a paltry 1.62% 40 years into the future.
The most intriguing part of this scenario is how much the long time horizon has compensated for investor 2’s final passive income and portfolio value despite such a huge difference in savings rate as compared to investor 1.
Investor 3 here is a smart guy with all three factors perfectly aligned. This person earns the same as the previously mentioned investors and has a savings rate of 10%, the same as investor 1. But this guy is smart and starts investing at the beginning of his career i.e at the age of 25. This investor benefits both from the high savings rate as well as from the 40 years long time horizon.
By the retirement age of 65, our investor 3 has a heavy nest egg of 1.22 million with passive income of about 20 000 annually from dividends, assuming the paltry 1.62% dividend yield, which we believe is a very conservative estimate.
Let’s add a fourth investor that has an exceptional savings rate of 15%, has below-average returns (5%), but a long time horizon.
By age 65, when he retires and withdraws to his cabin in the mountains, he has accumulated a portfolio worth 1.84 million, giving a passive income of almost 30 000. Even with below-average returns, the investor managed to create wealth, but mainly by being patient and invested over a long period of time.
First things first, the definition of being rich is relative to an individual. Being rich doesn’t mean sipping Hawaiian punches on the beach for everybody. Some people, even though already being rich with enough sustenance for another lifetime like to keep working because that’s what they love to do. Sitting ideal after retirement is not everyone’s dream.
But yes, it is an attractive investment and almost too compelling to pass. The above scenarios clearly outline the hows as well as answer the question. Yes, it is possible to get rich with dividends. With a decent dividend yield (not too high, not too low), a strong savings rate, and a decent time horizon, you can really build quite a portfolio of great value.
Disclosure: We are not financial advisors. Please do your own due diligence and investment research or consult a financial professional. All articles are our opinion – they are not suggestions to buy or sell any securities.