Better Investing Step 4: Compound Your Dividends

Welcome to fourth part in The Motley Fool's '5 Steps to Better Investing' series. So far, we covered the mental side of investing, the need to be patient. and then understanding the business risks in our investment candidates. The next step in our journey is the single biggest advantage that investors are offered, and the best way to take advantage of it.

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Welcome to fourth part in The Motley Fool's '5 Steps to Better Investing' series.

So far, we covered the mental side of investing, with Step 1, 'You don't have to make it back the way you lose it', and Step 2, Be Patient . We then went on to understanding the business risks in our investment candidates in Step 3.

The next step in our journey is the single biggest advantage that investors are offered, and the best way to take advantage of it.

Step 4: Compound your Dividends
Regular cashflow, when combined with the passing of time sounds like a relatively boring opportunity. Where's the excitement? What about the speculative miners or biotechnology pioneers?

As exciting as these opportunities are, the vast bulk of your return is likely to come from the perpetual motion machine that is the combination of time and cashflow.

The power of time
Time often gets a bad rap; blamed for lost opportunities, aging and decay. Less credit is given to its much more powerful counteracting benefit.

It isn't often that I get to delve into the scientific world of special relativity. That's probably just as well – it isn't my strong suit. However, one of the greatest scientific minds of human history – Albert Einstein – is supposed to have called compound interest either 'the eighth wonder of the world', the 'greatest mathematical discovery of all time' or 'the greatest wonder of the universe'.

There's some doubt as to whether any of the words really are his, but they are hard to disagree with. The phenomenon of compounding is responsible for many fortunes, and unfortunately for many more life-long financial struggles. It's a topic for another day, but it's the reason a $400,000 home loan at 7.25% will require almost $1 million in repayments.

The Rule of 72
For today, I want to concentrate on the positive aspects of compounding – the ability to grow your money over time.

You may have heard of the Rule of 72. It's mathematical shorthand, which allows you to make a rough estimate of how long it will take you to double your money.

You simply divide 72 by your rate of return to find out roughly how long it takes for your money to double. For example, if your return is 6%, it will take 12 years (72 divided by 6). If you get 10%, it's going to be a little over 7 years. The formula isn't perfect, but it's an easy mental exercise to get you started.

Let's say I'm lucky enough to be 21 again with $10,000 to invest, and I'm targeting a 10% return (ignoring taxes for now). Using the rule of 72, I've worked out that it'll take just over 7 years to double my money.

If all has gone to plan, at age 28 I'll have $20,000. So far so good, but the power of compounding really comes into its own at the end of that first period.

Layer upon layer upon layer
Over the subsequent 7 years, assuming the same return, I get to put the whole $20,000 to work – my original $10,000, plus the return I've just earned. This time, I earn $20,000 in those seven years, turning $20,000 into $40,000 at age 35. I now have four times my original investment.

If I'm disciplined enough to continue that process (and the hypothetical return doesn't change), in progressive 7-year periods, that $40,000 becomes $80,000, then $160,000 and then $320,000 by the time I'm 56.

The numbers themselves are impressive, but look just a little deeper. In that last 7 year period, I've earned $160,000 in investment returns – 16 times my original investment!

Just imagine what sort of nest egg you could build if you add to that growing pile with regular extra payments on a monthly basis!

Now – a very large disclaimer. No-one can predict the returns you'll receive, the returns are never linear, and I've excluded taxes – a simplification the ATO doesn't accept!

The power of dividends
The key point here is that money invested in productive assets will keep growing over time – and given a long enough period, the returns will dwarf your original investment.

In the United States, the Dow Jones Industrial Average has barely moved in the last 11 years (thanks largely to the irrational exuberance of 1999 and early 2000) and the GFC of the past few years. However, when we add in the dividends paid by those companies, the return jumps from around zero to 43%!

If you take those dividends and run, you can only spend them once. Reinvest them, and they'll work for you forever.

Foolish take-away
The old humourous election mantra is 'vote early, vote often'. We could do worse than adopt a version as our investing mantra.

It might require some work, but 'invest early, add often, reinvest always' is a reasonable start – time will do the rest.

Are you looking for quality stock ideas? Motley Fool readers can click here to request a new free report titled The Motley Fool's Top Stock For 2012.

More reading:

Five Big Threats In 2012

Scott Phillips is The Motley Fool's feature columnist. Scott owns shares in Microsoft. The Motley Fool's purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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