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Passive income is the main goal of many investors. But it may be the case that we don’t need the passive income right now. That is the situation for me right now. After all, I am working.
So instead of taking dividends from my investments, I can reinvest them each year. This allows me to benefit from something called compounding returns. Let’s take a closer look at how this works.
What are compound returns?
Compounding returns is essentially the process of earning interest on my interest by reinvesting my dividends each year.
At first, it doesn’t seem like a winning strategy, because after a year of investing in stocks that pay a 5% return, I’ll only get a 5% dividend and some share price growth if I choose well.
However, the longer I reinvest, the more money I will have in the end because the returns grow exponentially.
So if I invest £1,000 in dividend stocks and get an average annualized return 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 after a long period. After 20 years you would have £4950, after 30 years £10,900 and after 40 years a staggering £24,000. That is impressive growth. Over 40 years, my initial investment would grow in size by a multiple of 24.
what I would do
Investing regularly can help me grow my pot over time. You may want to employ a pound cost averaging strategy, which means that I invest a fixed amount every month in the same stocks. This can also provide some protection against the possibility of the market falling sharply after I have invested my money.
If I were to be in my 20s again, I would start investing regularly earlier. I would start by investing just £100 a month in dividend stocks and look to reinvest my earnings each year. I would also look to increase my contribution by 10% each year; I understand that this will require considerable contributions towards the end of the term.
Let’s assume my career is 45 years, taking me roughly from 21 to 66. If I were to use a compounding returns strategy, with the contribution plan above, and achieve a market average of 8% annualized total returns, after 45 years, would have 2.6 million pounds sterling.
At age 66, you could start using that passive income. If I were invested in stocks that pay a 4% dividend yield, I would receive £104,000 a year at retirement.
sensible choices
Obviously, the above is great. But investing involves risk. However, by making sensible investment decisions, I can seek to reduce that risk.
I would invest in companies like lloyds. It doesn’t offer a lot of growth potential, but I see it as a stable value. It also offers a dividend yield of around 4% and a Dividend Coverage Ratio (DCR) of greater than three. A DCR greater than two is normally considered healthy.
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