One of the simplest and most reliable forms of passive income is the collection of dividends from publicly traded companies. For those unfamiliar with dividends, a dividend is a payment made to shareholders as a way of sharing corporate profits with individual investors. Dividends can be made quarterly, monthly, or even annually depending on the company profile and philosophy. The payouts are made on a percentage basis and can range from 2-3%/year up to 5-10%/year (or more!). Once paid to investors, this money belongs solely to the shareholders and can be either reinvested in the company or cashed out and deposited into any bank account.
A dividend reinvestment plan, commonly referred to as a DRIP, is a special type of plan in which all proceeds from dividends are used to buy more shares of the underlying company. The reason for this re-investment is the power of compounding interest. (Anyone familiar with a typical 401k plan is likely aware that compounding interest can build substantial gains over a long period of time.) While the number of shares of a company grow over time, the total value of the annual/quarterly dividends grows as well. In addition, if the price of the underlying security grows in value, the gains are multiple even further!
Increasing the multiplicative power even further, some brokers will even let you invest a portion of your monthly earnings to purchase additional shares of the company. Typically allowing investments as little as $100/month, these additional share purchases can lead to further gains or help to spread investment risk over a variety of dividend paying companies.
Let’s take a look at an example:
If I were to spend $2,000 buying shares of Coca Cola (Ticker = KO) at today’s prices, I would wind up with about 50 shares. These 50 shares would each earn $1.24/year of dividends, for a total of $62/year. That may not sound like much, but by reinvesting that money into buying further shares of Coca Cola, I would own an additional 1.5 shares in just the first year alone.
I then decide turn off my laptop and leave this investment alone for the next 20 years. Logging back on sometime in the mid-2000’s, I would then find that I own over 85 shares after only a short period of time. Remind you, that’s 35 shares for FREE! Not only can those shares increase in value, but they will also earn their own dividends over time!
Now, lets take things a step further…
Let’s say I really believe in the future of Coca Cola and expect that the company will continue to grow over the coming years. To put my money where my mouth is, I choose to invest in a DRIP program through a broker and contribute an additional $100/month to my investment. I turn my laptop off just like before, except now when I turn my computer on 20 years later I find that I own nearly 600 shares, which is 12x what I started with!
At this point, I decide I want to retire, so I can decide to either cash out my future dividends of $750/year, or the entire value of the investment, which has grown substantially in value.
Rinse and repeat this strategy with a variety of different dividend paying companies, and you’ll have a portfolio that’s the envy of any Wall Street investor. So tell me, what’s your investment strategy? Do YOU have a favorite dividend paying company to share?