Imagine one of our forefathers from around 1,500 years ago going to a goldsmith with a couple of grams of gold and entering into a pact. The pact being that the goldsmith and his descendants get to keep the gold provided they add 5% to the total quantity of gold every year in the form of interest for the next 1,500 years. Since 5% is not a very high rate of interest, the goldsmith readily agrees and signs the pact. His descendants though are in for a rude shock. As things stand today, that tiny piece of metal weighing 2 grams has turned into an astounding 1.22 X 10^32 grams. To put into perspective how big this number is, it is more than 20,000 times more than the entire mass of earth! Well, the goldsmith's descendants would have defaulted a long time back.
This in a nutshell is what the enormous power of compounding all about. And even we can make use of its strength by investing in such a way that interest earned in a year is added to the principle and this new total is considered for calculating future interest. Follow this pattern sincerely for a few years and you will be surprised at the amount of wealth you would have accumulated at the end of the period.
Is there a technique that is more powerful than the compound interest? Indeed. And this technique does not run contrary to compound investing but uses the same principle and takes it a step further. Some prefer calling it compound interest on steroids. It is called so because here, the interest rate does not remain constant but keeps on growing year after year. What we are talking about is nothing but a stock that is able to increase its dividends year after year. Such a stock can easily be an investor's dream come true. This since not only do the reinvested dividends fetch dividends the next year, they also fetch a higher overall dividend by virtue of the dividend growth rates. Hence, they are able to generate much more returns than any instrument that compounds money at a fixed rate.
Put differently, Rs 100 compounding at a fixed rate of 5% will yield Rs 5 in the first year, Rs 5.25 in the second year and Rs 6.1 by the time the fifth year comes to a close. In contrast, a stock priced at Rs 100 and yielding Rs 5 as dividends but growing at 10% every year, will pay out Rs 9.2 as dividends at the end of the fifth year, 50% greater than the first case. We would however like to add a caveat that very few stocks are able to increase dividends for an extended period of time. The investor thus has to be really cautious while putting his money with the hope of benefiting from this strategy. Clearly, if a right stock is unearthed, there is no beating the strategy of dividend compounding, provided the dividends grow year after year.
By J Mulraj
This in a nutshell is what the enormous power of compounding all about. And even we can make use of its strength by investing in such a way that interest earned in a year is added to the principle and this new total is considered for calculating future interest. Follow this pattern sincerely for a few years and you will be surprised at the amount of wealth you would have accumulated at the end of the period.
Is there a technique that is more powerful than the compound interest? Indeed. And this technique does not run contrary to compound investing but uses the same principle and takes it a step further. Some prefer calling it compound interest on steroids. It is called so because here, the interest rate does not remain constant but keeps on growing year after year. What we are talking about is nothing but a stock that is able to increase its dividends year after year. Such a stock can easily be an investor's dream come true. This since not only do the reinvested dividends fetch dividends the next year, they also fetch a higher overall dividend by virtue of the dividend growth rates. Hence, they are able to generate much more returns than any instrument that compounds money at a fixed rate.
Put differently, Rs 100 compounding at a fixed rate of 5% will yield Rs 5 in the first year, Rs 5.25 in the second year and Rs 6.1 by the time the fifth year comes to a close. In contrast, a stock priced at Rs 100 and yielding Rs 5 as dividends but growing at 10% every year, will pay out Rs 9.2 as dividends at the end of the fifth year, 50% greater than the first case. We would however like to add a caveat that very few stocks are able to increase dividends for an extended period of time. The investor thus has to be really cautious while putting his money with the hope of benefiting from this strategy. Clearly, if a right stock is unearthed, there is no beating the strategy of dividend compounding, provided the dividends grow year after year.
By J Mulraj
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