Passive income is the main objective for many investors. But it can be the case that we don’t need the passive income right now. That’s the situation for me at the moment. After all, I’m working.
So instead of taking dividends from my investments, I can reinvest them every year. This allows me to benefit from something called compound returns. Let’s take a closer look at how this works.
What are compound returns?
Compound returns is essentially the process of earning interest on my interest by reinvesting my dividends every year.
At first, it doesn’t sound like a winning strategy, because after a year of investing in stocks paying 5% yields, I’ll only have 5% in dividends, and some share price growth if I pick well.
However, the longer I reinvest, the more money I’ll have in the end because the returns grow exponentially.
So if I invested £1,000 in dividend stocks and achieve average annualised returns of 8%, after 10 years, I’ll have £2,200. So I can more than double my money in a decade.
But the real returns come over a long period. After 20 years, I’d have £4,950, after 30 years £10,900, and after 40 years a staggering £24,000. That’s impressive growth. Over 40 years, my initial investment would grow in size by a multiple of 24.
What I’d do
Investing regularly can help me grow my pot over time. I may want to employ a pound-cost averaging strategy — meaning I invest a fixed amount every month in the same stocks. This can also provide some protection against the possibility of the market dropping sharply after my money is invested.
If I had my 20s again, I’d start regular investing earlier. I’d begin by investing just £100 a month in dividend stocks and I’d look to reinvest my returns every year. I’d also look to increase my contribution by 10% every year — I appreciate this will require considerable contributions towards the end of the period.
Let’s assume that my career is 45 years long, taking me roughly from 21 to 66. If I were to use a compound returns strategy, with the above contribution plan, and achieve a market-averaging 8% in annualised total returns, after 45 years, I’d have £2.6m.
At the age of 66, I could start drawing down on that passive income. If I were invested in stock paying a 4% dividend yield, I’d receive £104,000 a year in retirement.
Sensible choices
Obviously, the above is great. But investing involves risk. However, by making sensible investment decisions, I can look to reduce that risk.
I’d invest in companies like Lloyds. It doesn’t offer huge growth potential, but I see it as being a stable stock. It also offers a dividend yield around 4% and a dividend coverage ratio (DCR) above three. A DCR above two is normally considered healthy.
