How to grow the rate of a dividend stream by 1% (or more)

The previous post noted that 1% is bigger than you think relative to your dividend stream and the period of time required for it to double in size.  The concept involves compound annual growth rates (CAGR) and the Rule of 72.

I finished by saying I’d share ways to increase the compound growth rate of a div stream by at least 1%.  Here goes…

Transactions Costs 

There are two items involved here.  One is the actual cost of buying a stock.  The other is a function of investment size and frequency.  I’ll take cost first.

Cost:  Brokerages have charged $4.95 to $40 per trade over the years.  Given $500 to invest, spending $4.95 of it to make the trade puts roughly $495 to work in the portfolio.  Conversely, spending $40 on a trade gets $460 into a portfolio putting it $35 (7%) behind.  And it’s not even out of the investing gate.

 

Cut Your Transactions Costs

Another way to look at it is to assume a 10% dividend (makes the math easy) on the $460 portfolio which yields $46.00.  However, reducing transactions costs from $40 to $20 through a discount broker, means $480 in the portfolio and $48.00 in dividends at the end of the year.  The $2 dollar increase from $46 to $48 represents a 4% increase in my growth rate.  This doesn’t sound like much, but if you’ll recall the last post, it can make a heck of a difference.

Investment size and frequency:  Breaking an investment amount into multiple smaller increments vs pulling the trigger on one large stock purchase can make a difference as well.  Assume a $500 investment figure.  If it’s split across 5 purchases of $100 each with a brokerage fee of $4.95 per trade it means spending $24.75 on those stock buys. 

However, saving your powder and investing all $500 in a single trade, means spending $4.95 netting an additional $19.80 going to work in a portfolio rather than a broker’s pocket.  That $19.80 provides a 4.9% head start that widens further with time.  Trading often in small amounts puts a sneaky big dent in the compound growth rate.

It’s good to be aware of trade-offs on this point.  Spreading amounts across multiple smaller purchases is how some investors prefer to diversify.  Diversification is helpful, but the law of diminishing returns on risk reduction kicks in quickly.  Weigh diversification needs against transaction cost reduction to determine which route is a better fit.

Portfolio Yield 

As with transactions costs there are a couple ways to approach this.

Portfolio Yield

Whole portfolio yield:  This is easy to explain, but difficult to pull off.  If the stocks in a portfolio are each paying 4%, trading them all in for similar stocks paying 5% results in a 1% increase in the rate at which the dividend stream compounds.  This is easy but assumes no transactions costs or capital gains taxes are involved.  Beyond that drag, finding a basket of 5 percenters meeting the investing criteria of the 4% stocks they are replacing is challenging.  Consequently, the next method is more realistic.

Portfolio mix and weighted average:  This method takes analysis and is helped by the use of Excel.  The following example is an over simplification, but it demonstrates the point.  Let’s assume a portfolio of $1000 paying 4% produces a dividend stream of $40.  Split $50 (5%) from that $1,000 and invest it in a stock paying 8%, which is possible.  The $950 investment paying 4% yields $38 and the $50 investment paying 8% yields $4 for a total of $42.  The additional $2 is a 5% increase over $40 otherwise available.

Please note some investors consider allocating dollars to high yield stocks a way of introducing additional of risk – and rightly so.  However, a small amount of risk may be acceptable for investors as long as the additional risk is applied to a small segment of a portfolio that’s big enough to move the weighted average and increase the dividend stream by 1% or more.  This is one of those times when knowing your risk tolerance is important.  So is understanding the concept of opportunity – cost which is required to weigh the added risk against the added growth.

Dividend growth stocks

Dividend Dollars Multiply

These are a favorite of value investors.  Buying offerings in this category, particularly those with long records of growth, means raising the dividend paid nearly every year just by holding the stock.  Here’s an example of what that can mean.

 

Two portfolios of $1,000.  Both pay a 4% dividend.  Portfolio A does not raise its dividend while Portfolio B does so in small increments, say 3%, each year.  “A” delivers $40 year after year assuming no reinvestment.  However, “B” delivers $40 the first year and $41.20 the second year assuming no compounding. 

As you may have guessed, portfolio B grows the dividend stream by 3% relative to portfolio A.  Imagine what this delta can do over many years as the investment portfolio grows?  Think about what happens if this growth compounds along the way because all dividends are reinvested?  Dividend growth is powerful.  It takes patience and persistence.  It’s worth it.

There are several methods Dividend Farmers can use to increase the CAGR of their dividend cash flow.  These options don’t require exceptional skill or the addition of great risk.  Better still, they can be stacked to compound the compounding.  Reducing transaction costs, purchasing dividend growth stocks, and mixing in a pinch of high yield stock with a long history of steady payments can add 1% or more to the growth rate of your dividend income stream.

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