Financial independence might seem like an impossible dream for many, but if you put in place a set saving-and-spending plan, and stick to it, you will be surprised how quickly financial independence can become a realistic goal.
A strict budget and savings plan is the first stage of building your wealth. The next step is investing to make your money work harder for you.
The great thing about investing is that your money can work for you even when you’re asleep. Your earnings ability will no longer be constrained by your working hours. Instead, you’ll be able to benefit from the profits of other companies and other workers.
The power of dividends
Dividends and dividend stocks play a crucial role here. Many studies have shown that dividends provide the bulk of investment returns for investors over the long term and by reinvesting your dividends you can achieve investment returns that are far greater than the market average.
For example, if you have a £1,000 investment in a company that yields 5% per year, you would receive £50 per annum in dividends, much more than the current level of interest available on most savings accounts. If the dividend payout remained unchanged for 10 years, and for argument’s sake, the share price also remained unchanged, without reinvestment you would receive a total of £500 over the life of the investment, a return of 50%.
However, if you were to reinvest these funds at the end of the period, your investment would have grown to £1,551, an extra profit of £51.
This basic example illustrates just how powerful the strength of dividend reinvestment can be. To add to the example, let’s say the value of the share in question rose by 5% every year. This capital growth combined with dividend reinvestment makes a super-potent combination. According to my figures, in this example, if the dividend is paid only once a year, within a decade the combination of capital gains and income will have turned the initial £1,000 investment into £2,236. Most companies don’t pay out the same dividend every year. They try to increase the per-share dividend by at least the rate of inflation.
So, let’s assume that the company in our example increases its dividend payout by 5% per annum. In this scenario, assuming dividends are reinvested, a steady share price growth rate of 5% per annum and dividend growth, £1,000 will become £2,407 by the end of the decade sample period, almost £1,000 more than the example with no dividend reinvestment.
These are only simple examples but they clearly illustrate how important dividends are and how easy it is to build wealth by concentrating on the power of dividends and dividend reinvestment. If you’re looking to achieve financial independence, this is one shortcut that you definitely shouldn’t avoid. You should try to take as much advantage of the power of dividends as possible.
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Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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.