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Generating passive income from stocks is generally considered a strategy for investing in income. But there is no law that says we have to withdraw dividends.
By reinvesting my dividends and focusing on growth businesses, I am using a passive income strategy to build wealth for my retirement. As I will explain, I find this to be a powerful technique that could deliver impressive gains in the long run.
The magic of capitalization
Withdrawing dividends can be a good approach for income, but is likely to limit portfolio growth. When we withdraw a dividend, we are effectively taking away part of our investment capital.
Personally, I have never withdrawn a single dividend from my portfolio. I’m still working so I want to increase my properties as much as possible.
I use all my dividends to buy more shares.
In turn, these shares generate additional income for me, which I then use to buy even more shares.
This approach is known as compounding: reinvesting past income to generate more income in the future.
Compounding is a powerful growth technique over long periods. But it doesn’t necessarily generate a lot of growth in the stock price. For that, I rely on a second technique.
How do I target stock price growth?
A dividend represents a portion of a company’s profits. What remains can be reinvested in the business or used by the company to strengthen its financial position.
I look for companies that can successfully reinvest their retained earnings, so that their earnings continue to grow.
In turn, this typically leads to steady growth in dividends. And when the dividend increases, very often the share price does too.
A general rule of thumb I use is to add a stock’s dividend yield to its predicted dividend growth. The result is the expected total return of a stock over the next year.
This approach is based on the assumption that if a company’s dividend is increased, its share price will increase by an equal amount, so the dividend yield will remain the same.
Obviously, this doesn’t always happen, at least not from year to year. There is no formal link between dividend payments and stock prices.
However, over long periods, my experience suggests that it is a reasonable approach.
An example of this is the FTSE 250 Baker greggs. Over the past 20 years, Greggs’ dividend has increased by an average of about 11% per year.
During the same period, Greggs’ stock price increased at an average rate of 12% per year.
Obviously, this stock price growth has not happened in a straight line. But it has happened.
making a million
I believe that if I can invest in dividend growth stocks at attractive valuations, I should be able to achieve a long-term average return of 10% per year.
At that rate, how much would it take to earn a million?
If I were to invest £20,000 today and then add £200 to my portfolio every month, my sums suggest I could reach £1 million in 33 years, with a 10% annual return. Of course, you may not achieve that performance and you could even lose money.
But the beauty of this strategy, if it’s successful, is that when I’m ready to start earning income from my portfolio, I don’t have to change a thing. All I will have to do is start withdrawing my dividends, instead of reinvesting them.
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