Would you rather?

When I’m investing, I’m doing so for my future; for my family’s future; and to assist those in need when I can.  The goal is to grow my resources while mitigating risk along the way.  I want to maximize my return while minimizing the chance I’ll lose part or all of my investment.

In general, this can be accomplished in a couple ways.  I can put compound growth to work or I can depend upon the market valuation of my investment to appreciate through prevailing market mechanisms.  Which path would I rather?

Looking at the numbers helps me decide so I’ll start with a nice round number of $1,000.  This is a number many starting investors can put together, particularly if they’re working their budgets.

    

I’ll review three cases using a 10-year investment period.  In the first case, I’m assuming a 4% dividend compounded quarterly.  The second case assumes a 4% annual rate of appreciation.  The third case assumes a 4% rate of return for the full 10-year period.

 

In the case of the full 10-year period, I assumed a worst-case scenario – getting a total 4% return for the decade.  To run this exercise, I used the Future Value (FV) function in Excel.  The table below shows the inputs for the FV formula, the results, and the percentage change between the starting or Present Value (PV) and the ending or Future Value (FV).

	Quarterly Compound	Annual Compound	Period Compound
PV	$      1,000	$         1,000	$      1,000
iRate / Year	4.0%	4.0%	4.0%
iRate / Period	1.0%	4.0%	4.0%
Years	10	10	1
PMT	0	0	0
PV	$1,488.86	$1,480.24	$1,040.
Increase	49%	48%	4%

• 4% dividends compounded quarterly yields a 49% increase relative to my starting value.
• 4% value appreciation annually yields a 48% increase over my starting value.
• 4% value appreciation for the entire 10-period yields a 4% increase above my starting value.

Compounding obviously has advantages.  The more you do it, the better the outcome.  Understanding this as an investor is straight forward math.

The sticky part is figuring out which method results in the lowest total risk.  Determining this becomes subjective, but I’ll give it a shot.

If I invest in a Dividend Champion with an extended history of dividend payments or better still, growth, there is a reasonably good chance that long history will repeat itself into the future.  Companies with solid dividend histories have a vested interest in continuing the trends and won’t take undue risks to avoid dropping the ball.  They’ve also demonstrated they can generate cash with which to pay those dividends.

Should I invest in a non-dividend payer hoping the market value increases by at least 4% annually, I’m counting on Mr. Market to work in my favor every year for 10 years.  Given Warren Buffet’s quote, I think the probability Mr. Market will come through for me in 10 successive years to be slim.  Even if he does, I’ll still fall 1% short of what might happen by compounding dividends.

As for the third option, it’s a non-starter. 

Although it’s possible non-dividend paying stocks may experience a tremendous increase in some years, it’s also likely they may succumb to a serious decline as well.  The rollercoaster ride can reduce my total return beyond the 1% delta shown between options 1 and 2 above.  While a dividend payer can experience ups and downs as well, their gyrations are relatively subdued. 

Overall I’ve determined the greatest probability of long-term success is found in avoiding big losses while generating small, consistent gains that compound over time.

To be fair, analysts will point out that dividends paid, even if retained and compounded, result in tax bills reducing my return while non-dividend payers can appreciate tax free until they’re sold.  This is true, but I’ll take the relatively sure compounding rate, even with a tax bill, over the ethereal value appreciation approach and no tax bill.  For me, it’s better to have a few bucks and pay pennies on it than having nothing and pay nothing.  Which would you rather?  

The thoughts expressed here are those of the author, who is not a financial professional.  Opinions should not be considered investment advice.  They are presented for discussion and entertainment purposes only.  For specific investment advice or assistance, please contact a registered investment advisor, licensed broker, or other financial professional.