Through its sizeable compounding effect, dividend snowball investing can help investors build a passive income and massive wealth in the long run.
The dividend snowball leverages reinvesting dividends to purchase more shares using a dividend reinvestment plan (DRIP). To reap maximum benefits from long-term dividend snowball investing, you need to pick high-quality dividend growth stocks.
This article explores every aspect of dividend growth investing and how you can make the best use of this strategy.
What is the first thing that comes to your mind when you hear the word “Snowball”? A small and insignificant white ball that becomes larger and larger when you roll it. Dividend Snowball investing works on the same principle.
The initial dividend payments that you receive are usually small, but you reinvest the amount and purchase more of that stock to earn a more significant dividend in the future.
Small dividends snowball into larger dividend payments in the future because you’ll own more shares, and the company will likely pay higher dividend rates over time.
An investor can voluntarily reinvest the dividends or sign up for a Dividend Reinvestment Programme (DRIP) wherein the company directly reinvests the dividend.
This article will explain how Dividend Snowball investing works and its advantages. We will also delve deeper and learn the key factors to consider before opting for a dividend reinvestment strategy.
What is a Dividend Snowball Investing?
You have probably heard about David Ramsey’s debt snowball method, where the borrower pays the smallest balance first and then allocates the rest of the money to other debts. The allocation amount is based on the outstanding balance, speeding up a borrower’s debt repayment process. The dividend snowball method is like an extension of this concept, though slightly different.
The dividend snowball investing leverages the compounding effect by reinvesting dividends to purchase more shares.
As you keep reinvesting, the number of shares grows larger, paving the way for larger dividend payments. If you choose exceptional companies and keep reinvesting over a considerable period, the results could be fantastic! In other words, the dividend snowball method is a constant effort toward growing your dividends.
To reap maximum benefits from dividend snowball investing, you need to pick high-quality dividend growth stocks, such as those from Dividend Aristocrats and Dividend Kings. The S&P 500 Dividend Aristocrats is a stock market index composed of S&P 500 companies that have increased their dividends in each of the past 25 consecutive years. Similarly, Dividend Kings have increased their dividends in the past 50 years.
According to an analysis from Hartford Funds, 78% of S&P 500 returns going back to 1978 can be attributed to dividend reinvestment and their resulting compound returns.
There are two ways you can reinvest dividends: either by taking the cash and purchasing additional shares through your broker or by using an automatic dividend reinvestment plan (DRIP). In these cases, instead of paying dividends, the company automatically reinvests it into more shares.
If you don’t reinvest the dividends, you will have to depend on the companies to raise their dividend rates, usually annually.
How does Dividend Snowball Come into effect?
Company-Operated DRIPs: A few blue-chip dividend-paying companies operate their DRIPs. For instance, Coca-Cola and Johnson & Johnson offer their own direct stock purchase plans and DRIPs, which reinvest the dividends earned on the stocks.
Third-party DRIPs: Many dividend-paying companies outsource their direct stock purchase plans and DRIPs management to third parties or transfer agents. Please note that these agents usually charge a fee from investors.
Brokerage DRIPs: Most brokerages or robo-advisors also facilitate DRIP investing through a simple process. You need to pick your dividend stocks into your brokerage’s DRIP, and when you receive a dividend payout in your account, your brokerage will reinvest it in new shares. This is probably the easiest way to implement dividend snowball investing.
Self-Implemented DRIPs: In some cases, wherein your chosen dividend company that doesn’t offer a DRIP plan and no brokerage or third party also facilitate dividend reinvestment, you can manage it independently. You simply need to reinvest your dividends to purchase whole or fractional shares for the corresponding amount. This process is more cumbersome, but you can receive advantages of compounding and dollar-cost averaging.
How does Dividend Snowball Investing Work?
Now that we know the potential of a dividend snowball method, it’s time to see how it works.
You can use a dividend reinvestment calculator to assess how your investment grows over a period compared to when you don’t reinvest. The basis for the dividend snowball effect is the power of compounding which means they are added back to the initial invested amount – not to determine capital appreciation.
Therefore, the formula for dividend reinvestment would be as follows:
FV = P * (1 + r / m)^mt,
- FV – the future value of the investment or the final amount.
- P – the initial investment
- r – the dividend yield or the ratio of the annual dividend to share price
- m – the compounding frequency
- t – the number of years for investment
Let’s understand this with the help of an example. Let’s say you want to invest $2,000 in a dividend-paying stock for three years. The dividend is compounded annually, which implies that it is added every year and is used to purchase new stock.
Our share price is $72, and the annual dividend is $4.00. The number of shares that you can purchase is $2,000/$72= $27.77
Please note that owning fractional shares are allowed under the dividend reinvestment policy.
This would give us a dividend yield of:
DividendYield = $4.00 / $72 = 0.055 or 5.5%
When we enter all the variables into the dividend reinvestment formula, we get:
2000 * (1 + (0.055/1)^(1*3) = $2,352.19
Therefore, the profit from dividend reinvestment is $352.19.
Imagine now that the share price has increased to $75. You can purchase $352.19/$75= 4.69 shares extra with the reinvestment profit.
Steps for Dividend Reinvestment
- Choose good dividend growth stocks with a history of annual dividend increases. However, ensure that the payout ratio doesn’t exceed 75%. A payout rate on the lower side means that the company is more likely to increase dividends in the future.
- Consistency is key to the Dividend Snowball game, so contribute every month to purchase if you receive enough dividends. Buying dividend stocks every month ensures dollar-cost averaging, which helps lower short-term volatility in the broader equity market. This is one of the best ways to create stable income over the long term.
- Reinvest the dividends to buy more shares and accelerate your dividend growth. Moreover, there’s no commission for reinvesting dividends; it is a win-win for long-term investors.
- The Dividend Snowball method requires continuous investment, typically ranging between 5 years to 20 years. Hence, time and patience are the names of the game here. The Benefits Of The Dividend Snowball Method
The dividend Snowball Method is one of the best ways to create a solid long-term passive income, and this is because of two primary reasons:
Dollar-Cost Averaging: DRIPs offer a way to accumulate more shares without the need to pay a commission. Several companies offer shares at a discount of 1% to 10% of the current share price through their DRIP. With discounts and no commissions, the cost basis for owning the new shares is much lower than that purchased in the open market. Through DRIPs, investors can also buy fractional shares, making every dividend dollar functional.
Power of Compounding: The most significant advantage of dividend growth investing is compounding returns. When dividends increase, shareholders receive an enhanced amount on each share they own, through which they can purchase more shares. Over time, this results in the increased total return potential of the investment. As more shares can be purchased with the decline in stock price, there is more likelihood of long-term potential for more significant gains.
Superior Returns: One of the essential elements of dividend growth investing is that only outstanding companies can grow and pay dividends simultaneously. There’s a common misconception that companies with high dividends grow earnings slower. But the opposite is true. Robert Arnott and Cliff Asness show that dividend payers generally have higher earnings growth in the paper, “Does Dividend Policy Foretell Earnings Growth?”
How to Implement The Dividend Snowball in Your Retirement Account
Most investors focus on safe retirement with a substantial corpus of funds and spend their entire lives on asset-building. Investing in dividend-paying stocks and opting for the dividend snowball strategy is one of the best ways to enhance retirement income.
Over time, the cash accumulated from those dividend payments can be an additional fund flow alongside your Social Security and pension income. If investors do a little planning, they can earn a considerable amount from dividend income.
Using dividend payments to buy more stock is an intelligent strategy for people planning to save for retirement. Through this method, they will receive more significant dividends in the future.
However, investors need to plan well and have other short-term income sources before relying on dividend reinvestment. Investors can plan to diversify their retirement savings across additional liquid funds, individual retirement accounts (IRAs), and 401(k) plans. This goes a big way to ensure that the retiree has enough savings and can survive without the immediate cash from dividends.
Dividend reinvesting or the dividend snowball strategy is quite a long-term strategy. Investors typically have to continue reinvesting their dividends post-retirement because most dividend earnings are too small to meet their immediate needs.
Those dividend payments will not be able to make a massive difference to a retiree’s annual income. However, if an investor consistently reinvests these dividends every year, they can expand their portfolio without foregoing any additional income. The dividend snowball strategy is one of the simplest and most cost-effective ways to enhance retirement holdings over time.
Classic dividend growth stocks like Procter & Gamble and Coca-Cola are retirees’ best friends. These stocks usually raise their dividend rates, which helps generate inflation-beating returns in the future. By adding such stocks to a retirement portfolio, investors let go of the current dividend yield for a larger payment in the future.
Most retirement savings avenues require participants to take a minimum distribution by a specific age. Hence, retirees can withdraw from these accounts after retirement and use that income to sustain their livelihood, leaving them with enough leeway to reinvest their dividends.
Though dividend snowball has a lot of potential, it may not be suitable in every case. It may be the right strategy in the early stages of retirement. Still, it may become less profitable over time if a retiree incurs increased medical expenses or reaches to end of his savings accounts.
Dividend Snowball Effect and Taxation
Before implementing the dividend snowball strategy, an investor must also know its tax implications. A dividend is a taxable income, so even if you reinvest them before receiving it into your account, it will be recognized as an income under IRS.
Form 1099-DIV lists Dividend income as either non-qualified or qualified. Dividends from real estate investment trusts (REITs), employee stock options (ESOP), or master limited partnerships (MLPs) are non-qualified dividends. At the same time, dividends from US-based stocks and funds are qualified dividends.
Non-qualified dividends are taxable at the ordinary income rate, while qualified dividends are eligible for favorable tax treatment similar to long-term capital gains taxes.
Things to Consider Before Implementing a Dividend Snowball Strategy
The dividend snowball effect is undoubtedly one of the best strategies to accumulate larger dividend earnings over a period. However, certain principles hold the key to a well-performing dividend reinvestment policy.
Before implementing a dividend snowball strategy, you need to:
- identify quality dividend stocks,
- lock-in reasonable compounding rates, and
- have the patience to let the snowball effect do its work.
There are some more guidelines to make sure that this strategy produces the best results:
Ensure high-quality dividend stocks: Long-term quality stocks are the ones that deliver high returns on equity and possess strong competitive advantages that sustain such returns over extended periods. If the underlying asset is poorly performing, dividend reinvestment may not be the right choice. Securities go through phases of ups and downs, but if your dividend-bearing asset is not providing the desired value, then it is time to collect those dividends instead of reinvesting them. The company should demonstrate constant growth: Another point to note is that if the stock’s cash flow is declining but continues to pay increasing dividends, you may want to look for alternative investments unless you’re sure this is a temporary lack of performance.
Beware of portfolio imbalances: Reinvesting dividends over the long term helps grow your investment, but in just one security. When you examine your investment portfolio, you may find it to be highly inclined towards a few assets. It’s an advantage when these securities perform well, but the losses will be that much more significant when they don’t.
The Bottom Line
Dividend Investing is one of the most powerful strategies for creating passive income and post-retirement income from a continuously compounding dividend portfolio. You automatically take advantage of market downturns due to consistent buying via a DRIP, and you buy higher-quality companies as few companies can grow and pay dividends simultaneously.
The dividend snowball method might be an excellent choice for those who are more interested in a low-effort investing strategy.