Some people invest to create a second income stream, others invest to build wealth over the long run and retire early. I invest with the latter in mind as I don’t need the money I earn through dividend payments right now.
So let’s take a look at how I’m trying to generate wealth in the long run.
Compound interest is core to my strategy of building long-term wealth. Income stocks provide me with regular, but not guaranteed, payments. However, I rarely take this money to fund my life. Instead, I reinvest my dividend payments. This is a process called compound returns, or compound interest.
It might not sound like a winning strategy, but it really works if I leave my money invested for a long period of time. For example, if I invested £10,000 in a company with a 5% yield, at the end of the year, I could expect to have £10,500. That’s assuming the share price stayed the same.
But what if I reinvested that dividend every year and earned interest on my interest? Assuming the dividend remains at 5% and I keep reinvesting it, I could expect my £10,000 to be worth £47,000 in 30 years. That’s the power of compounding.
But I can also supercharge this process by adding more money every month. If I added as little as £200 a month, after 30 years, I’d potentially have £211,000.
That’s the further power of compounding and this could help me retire early.
Some 30 years ago, the FTSE 100 was trading at around 2,500 points. In August, it crossed 7,500 before falling again in recent weeks. So over the past 30 years we’ve seen the value of the top 100 UK companies triple.
This is by no means indicative of future performance, but I would hope to see the index grow over the next 30 years. So if I pick my dividend stocks well, I could also have plenty of organic share price growth to add to my compound interest strategy. But I have to accept that my investments might go down as well as up.
If I was starting investing today for long-term, compound-interest-enhanced gains, I’d want to look at stocks offering reliable and sustainable dividends. That’s why I’d look at firms such as Lloyds, which currently offers a 4.9% yield. It’s got a history of strong yields and it operates in a stable area of the market. It’s also important to remember that the dividend yield is always specific to the price I pay for the stock.
Likewise, I may look at stocks that I think will outperform the market in terms of growth in the coming years. Hargreaves Lansdown offers a 5% dividend yield but I think it has considerable upside with regards to the share price. The company provides a supermarket platform for shares and funds and I think this stock will benefit as more and more people look to take control of their investments.