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Here’s why dividend stocks could enable you to retire early

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When I first started investing — or, rather, dabbling — in the stock market, I was attracted to little AIM shares with exciting ‘growth stories’. They didn’t pay dividends. In fact, most of them didn’t even make a profit. They promised ‘jam tomorrow’.

Companies that paid dividends — such as GlaxoSmithKline, National Grid and Unilever — were for retired people, weren’t they? What was the point of a few quid in dividends each year for a young go-getter like me, when the share price of some small-caps could double in a matter of weeks, or even a single day?

However, it didn’t take me too long to discover that punting ‘jam-tomorrow’ stocks was rather like playing roulette. That’s to say, plenty of buzz and excitement, with big highs and lows — but, ultimately, over time, distinctly unprofitable.

I came to learn that dividend stocks weren’t just for old folks wanting income, but that dividends were a ‘secret sauce’, which, when combined with a long-term investing horizon, could make a young investor seriously wealthy.

The compounding miracle

I’m sure I’m not the first person who came to the stock market with no appreciation at all of the ‘compounding miracle’ of reinvesting dividends.

Recent data from Morgan Stanley/Woodford Asset Management is just the latest to demonstrate the extraordinary returns produced by reinvesting dividends over long periods. The data shows that the capital value of £1,000 invested in the UK stock market in 1926 would have grown to a bit over £100,000 today. However, with dividends reinvested, that same £1,000 would have grown to £7.8m!

Keeping it simple

The simplest way to invest in the market and benefit from the compounding miracle of reinvested dividends is to buy a humble, low-cost tracker fund, which gives you the return of an index — such as the FTSE 100 or broader-based FTSE All-Share — less a small charge taken by the fund manager.

And you’d want to buy the accumulation units of the fund, in which dividends are reinvested for you, rather than the income units, where the dividends are paid out.

Doing it yourself

Of course, most stock market indexes include some companies that pay no dividend or only a token payout. This is one reason why some investors, who appreciate the power of dividends, prefer to build their own portfolios of dividend-paying stocks — diversified by size, industry and geography to reduce risk.

Diversifying by size of dividend yield can also be sensible, because a company with a high yield may not increase its payout as fast as one with a lower yield. For example, Royal Dutch Shell, which currently yields 6.7%, has only increased its dividend by 10% from five years ago, because its earnings have been depressed by the low oil price. In contrast, thriving asset manager Schroders, which currently yields 3.3%, has more than doubled its dividend over the same period.

However, be wary of yields that are too high. A yield in high single digits or double digits is often the precursor of a dividend cut, as we saw with Lloyds and many other financial stocks as the financial crisis unfolded.

But whether you choose to put money into an index tracker or a portfolio of individual stocks, if you start early enough, keep investing and reinvest dividends, history says you might well find you can retire earlier than you expected.

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G A Chester has no position in any shares mentioned. The Motley Fool UK owns shares of and has recommended GlaxoSmithKline and Unilever. The Motley Fool UK has recommended Lloyds Banking Group and Royal Dutch Shell B. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.