I’ll start the blog post with a quote from one of the smartest men that ever lived.
“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” – Albert Einstein.
If you have taken math in school, you probably have come across the idea of compound interest. It’s a simple mathematical concept that shows the power of reinvesting the interests received from your principal. Since I’m a math nerd at heart I want to show you the standard compound interest formula.
What do the funny characters stand for?
P stands for the initial capital
r stands for the annual rate of interest (as a decimal)
t stands for the number of years the amount is deposited for
n stands for the number of times the interest is compounded per year
A stands for the final amount of money that you’ll get
With this formula in hand, I can show you the power of compound interest.
Imagine that I invest $5,000 at 5% annual interest rate for a year. If the interest is compounded annually I’ll get $5250 at end of the year. If I invest the entire amount for another year, I’ll get $5,512.5 at end of the 2nd year. Here’s what happens if I leave the money for 5 years and keep reinvesting the interests.
Year 0 – $5,000.00
Year 1 – $5,250.00
Year 2 – $5,512.50
Year 3 – $5,788.12
Year 4 – $6,077.53
Year 5 – $6,381.41
At end of the 5th year, my $5,000 initial deposit has grown to $6,381.41, or an increase of $1381.41. Because the interest is compounded each year, the actual annually return is greater than 5%. In this example I’m actually getting 5.52% annual return, an additional 0.52% more than the annual interest rate by simply doing nothing an reinvesting the interest. How cool is that?
The power of compound interest becomes even more apparent when I leave the money for a longer period. Let’s say I leave the money for 10 years. At end of the 10th year, my initial deposit would grow to $8,144.47. An increase of $3,144.47 or an annual return of 6.29%. The extra 1.29% is possible because the interest is compounded over 10 years, providing me with a better return.
What if other parameters like r and n change? Life gets a lot more exciting!
The interest rate is now 10%. An initial deposit of $5,000 would give me $8,052.55 at end of the 5th year. That’s an increase of $3,052.55, or an annual return rate of 12.21%! An extra 2.21%! Nice!
The interest rate stays at 10% but instead of compounding the interest annually, the interest rate is compounded monthly. At end of the 5th year, my initial deposit of $5,000 would become $8,226.55. That’s an increase of $3,226.55, or an annual return rate of 12.9%. Compared with scenario 1, an extra $174 is earned by simply compounding the interest monthly.
Consider the same parameters as scenario 2 but instead of monthly compounding, the interest rate is compounded weekly. A $5,000 deposit would give me $8,239.65 at end of the 5th year, or an annual return of 13%. That’s an additional $187.10 than scenario 1 or an additional $13.10 than scenario 2.
If I make monthly contributions on top of the initial deposit, both the initial deposit and the monthly contributions are earning interest. The power of compound interest really takes off when regular contributions are made!
The power of compound interest is like rolling a small snowball down a long and steep hill. Initially the snowball is small but as it travels down the hill it starts picking up snow. The snowball slowly becomes bigger and bigger. As the snowball grows, it begins to roll down the hill at a faster and faster speed. Eventually the snowball becomes so big and so fast it’s unstoppable! Watch out!
This is the same concept that I would like to apply to our dividend portfolio. But how does this work? How does compound interest relates to dividend investing?
The answer lies in a very useful investing strategy called dividend reinvestment plan (DRIP).
A little background about the different types of DRIPs – regular DRIP and synthetic DRIP.
Regular DRIP is usually done through a transfer agent like ComputerShare. It requires you to acquire at least one share in a company and obtain the share in paper form. You then have to fill out DRIP enrolment forms and send them to the transfer agent for the company that you’ve chosen. Once regular DRIP is set up and running, the entire dividend amount is reinvested. In other words, fractional shares can be purchased. This is an effective way to build up your dividend portfolio with a small amount of capitals. This is a method that I’m currently set up for our son, baby T’s, dividend portfolio. That topic is for another post in the future.
You can find more information about regular DRIP on Canadian DRIP Primer.
Synthetic DRIP is what’s offered by discount brokers like TD Waterhouse and Questrade. With synthetic DRIP, only full shares can be purchased. If the dividend amount received is less than the price of the share, no share is purchased. Synthetic DRIP requires you to own sufficient amount of shares to enrol. For example, Royal Bank (RY) currently pays out $0.75 of dividend per share each quarter. In order to enrol in synthetic DRIP with your discount broker at current price of $82, you would need at least 110 shares of RY, or $9,020 ($82/$0.75 in case you’re wondering). Typically you want to invest more than the minimum amount of shares required in case the price of Royal Bank continues to go up. In this case 125 shares of RY would probably gives enough buffer to make sure enough dividend is received to cover the stock price.
Regular DRIP is powerful because the entire dividend amount is reinvested. The only downside is that you need to deal with fractional shares when calculating the cost basis. This could lead to some messy accounting. Synthetic DRIP, on the other hand, only purchases full shares, making accounting simpler.
How does all this information relate to our dividend portfolio? As mentioned in my dividend investing approach previously, I try to reinvest dividends whenever I can. Since our investment accounts are with TD Waterhouse and Questrade, we can only utilize synthetic DRIP. Whatever dividend money left over from synthetic DRIP is accumulated with other dividend incomes and to be used to initiate other positions.
Take the Royal Bank example again, I’ve made several purchases throughout the years to finally accumulate enough shares to start synthetic DRIP. Although initiating new positions to further diversify is very important, I’m always looking to add to our existing positions so synthetic DRIP is possible.
Enrolling in DRIP has definitely helped us in harvesting the power of compound interest. With our dividend portfolio, the current forward looking dividend is about $8,500. If I were to take out the forward dividend amount gained from the DRIP’ed shares, our forward looking dividend would drop to about $8,000. By utilizing DRIP and the power of compound interest, we are able to make additional $500 in our dividend income!
As I pointed out in the compound interest scenarios, the number of times the interest is compounded per year makes a significant difference. This is true for DRIP as well. Typically dividends are paid out quarterly, so the interest is compounded 4 times each year. However if you were to invest in stocks that pay monthly dividends, you would be compounding your dividend 12 times each year. The compounding effect takes off very quickly after a few years.
A word of caution on DRIP. If you’re DRIPing REITs or income trusts it’s best to hold them in registered accounts like RRSP or TFSA to avoid complicated tax calculation.
Do you utilize DRIP to power boost your dividend portfolio?