The secret to powerful wealth creation isn’t really a secret at all. It just takes two things: time, and the magic of compound interest.
Albert Einstein referred to the latter as the “eighth wonder of the world” and the “strongest force in the universe.” Ben Franklin called it a “miracle.”
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And old Ben put his money where his mouth is. Literally. Upon his death in 1790, Franklin bequeathed a gift of 1,000 pounds (about $4,400) each to his favorite cities of Boston and Philadelphia with instructions that the money draw uninterrupted interest for 100 years. After that, a portion could be withdrawn for public works projects and loans to aspiring tradesmen and the rest would continue to gather interest.
It’s a fascinating tale. But I’ll skip straight to the end. Exactly two centuries later, in 1990, the Boston endowment had ballooned to approximately $5 million in value, much of which was used to fund the Franklin Institute of Technology. Philadelphia spent more along the way, but still accumulated over $2 million, devoting a good chunk to scholarships for area students.
Of course, you and I can’t wait that long. But even over 10 or 20 years, you can harness the power of compound interest to build wealth. And it takes only a small initial investment to start...
A Primer On Compounding
You probably already know that blue-chip, dividend-paying stocks have provided the bulk of the market’s return over time. But many younger workers make the mistake of taking their dividend payments in cash, without realizing that simply reinvesting those quarterly checks could easily put an extra $125,000 in their account by retirement age.
Let me quickly show you how powerful compounding can be...
If history is any guide, you can expect your investments to grow about 6% to 8% annually over the long-haul. A 6% gain on a $50,000 portfolio may not seem like much, but 6% year after year on an ever-rising base of assets starts to really snowball. That's compounding. You may tend to think of it more with respect to savings accounts or other interest-bearing items, but it also works with dividends.
Suppose you set aside $6,000 this year (I'm assuming you're 40 years old in this example). That money will earn $360 in 12 months, assuming the aforementioned 6% rate. In year two, you will earn 6% again, but on $6,360, rather than $6,000. That’s right, your interest itself begins to earn interest.
Assuming you keep contributing $6,000 to your account each year, here’s how your money would grow. Keep it up for five years, and you've bagged $3,800 in gains in addition to the $30,000 you've put in.
|A Decent Gain|
Now let's say you keep it up for another 10 years, picking up 6% annual gains on the nest egg along with another $6,000 in freshly injected funds each year. Now compounding is really starting to pick up. You've put in $90,000 ($6,000 a year times 15 years), but also have a nearly $50,000 gain to show for your efforts.
The next 10 years, your results are better still. You've now put in $150,000 ($6,000 a year times 25 years), but made even more than that in profits. When you're looking at 6% gains on $300,000, the annual earnings really start to pile up fast.
And if you stick with it for 10 more years, you'll now be sitting on a really impressive pile of cash.
|Strong Annual Returns|
By the time you hit 74, you'll be bagging nearly $40,000 in annual gains -- far higher than the $6,000 you've been injecting each year.
Aside from building a comfortable nest egg, this passive investment strategy has other perks as well. If nothing else, it means you don’t have to stay glued to the finance channels looking for the next "hot" stock. Nor do you have to pay too much attention to the latest GDP forecast or whatever the fed is saying.
The numbers above, while compelling, are purely a mathematical exercise. In reality, what you are doing is receiving dividend income, using the proceeds to buy more shares. Those shares then generate more income, which leads to even more shares, which leads to more income…
Ben Franklin put it more eloquently, when he said, "The money that money makes, makes more money."
Suppose you call your broker and place an order for 1,000 shares of XYZ (a reliable dividend payer) at a price of $10 per share, for a total investment of $10,000. The stock offers an annual dividend of $0.50 per share (5.0% yield). So over the next 12 months, you will collect $500 in dividend payments (1,000 shares * $0.50).
You could take the cash and spend it. But that gets you nowhere fast. To truly build wealth, you need to reinvest these distributions, which purchase 50 more shares ($500/$10). So at the end of the first year, your position size would have grown from 1000 shares to 1,050 shares. And here’s where it gets fun.
In the second year, those new 50 shares themselves generate dividend income. And so on.
After 10 years, you will have accumulated 1,628 shares with a value of $16,289. By contrast, if you pocketed the cash instead of reinvesting, you would have the same 1,000 shares you started with, collecting a flat total of $5,000 in dividends along the way – but missing out on $1,289 in gains.
That may not sound like too much. But keep in mind that this hypothetical example assumes zero growth in the stock, zero additional investments, and zero increase in the dividend. So you can imagine the potential with a company whose dividends and shares are steadily growing each year.
Let's run the same numbers, but assume a longer 25-year time frame, for a 40-year old until retirement age at 65. Let’s also assume that the share price and dividends are both growing 8% a year. Now, let’s see the difference.
|Total Dividends Paid||Ending # of Shares||Total Ending Value Including Dividends|
As you can see, reinvesting the dividends would put an extra $124,000 in your account – from the exact same stock earning the same annual return.
By retirement, the $0.50 per share annual dividend would have grown to $3.42 per share. And you would be sitting on 3,386 shares, three times the number you started with. That would provide an annual income stream of $11,580 – more dividend income each year than the $10,000 you initially invested. And that’s with only one contribution in the first year, nothing out of pocket thereafter.
If that doesn’t get your attention, consider this. A single share (just 1) of Coca-Cola bought in 1919, with dividends reinvested, would have grown to $9.8 million by 2012.
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(This article originally appeared on StreetAuthority.com.)