Dividend reinvestment has become a popular way to create a stream of passive income and build true wealth. But I wondered if you can become rich just by reinvesting earned dividends. I conducted some historical backtests of different portfolios and these are the results.
Dividend reinvestment can increase returns by up to 2% per year. This means that after a period of 30 years your portfolio value would be nearly twice as high compared to not reinvesting dividends. So, yes, dividends can make you rich (or at least richer).
In this post, we’ll cover why dividends reinvestment can make you richer and how to become wealthier by reinvesting dividends. We will also look at the downsides of reinvesting dividends and discuss if there is a good age to stop reinvesting dividends.
Can you get wealthy from dividends?
As discussed in the opening paragraph, you can get wealthy from dividends alone! The increased returns of 2% per year refer to the compound annual growth rate (CAGR) of your portfolio and is a common metric to measure portfolio success.
|Portfolio||Initial Balance||Final Balance||CAGR|
In the table above you can see a comparison of two portfolios: one with dividends reinvested and one without. The portfolios each start in 1992 and hold the entire U.S. stock market (VTSMX). As you can see the difference in results is quite astounding!
With just an initial balance of $10,000, a portfolio without dividend reinvestment would have reached over $84,000 by today, whereas the portfolio with dividend reinvestment would have exceeded $146,000!
If we look at the portfolio growth visually the differences become even more apparent. Here’s the chart of the portfolio with dividends reinvested:
Although dividends have been reinvested all along the way, the majority of growth occurred in the last decade from 2010-2020.
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Why dividend reinvestment can make you richer
While dividend reinvestment alone will not make you part of the 1%, it surely is a step in the right direction. There are several factors that contribute to your overall wealth growth when reinvesting dividends:
- Compounding: Einstein famously said that compound interest is a miracle and he was right! Just by compounding an extra 2% each year, your portfolio value can nearly double in 30 years.
- Reduced Spending: When you reinvest dividends instead of having the paid out you automatically reduce your spendable income leading to reduced expenses and increased savings, or in other words, your savings rate goes up.
- Fewer Fees: Many brokers offer so-called dividend reinvestment plans (DRIPs) that allow you to purchase fractional shares of those same companies without or with very little fees. And fewer fees equals more wealth to compound!
Thus, dividend reinvesting can not only offer tremendous financial upside but also help improve your investment behavior and spending psychology by reducing the available income and creating artificial scarcity.
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How to become rich by reinvesting dividends
Let’s take a look at how reinvesting dividends can actually make you wealthy in the true sense of the word, i.e. financial independence. Fortunately, there are some handy calculators out there that let you estimate your early retirement date:
This graph shows the exact point where your investment income surpasses your annual expenses, i.e. the point of financial freedom. Now, to adjust for dividend reinvestment, we need to change the expected stock returns by 2%.
Let’s see how the graph changes if we reinvest dividends and thus increase stock returns by 2% annually.
And wham! Just by reinvesting dividends you have shaved off a whole year from your 9 to 5 work life and have earned one extra year of freedom. Well, is the delayed gratification of reinvesting dividends worth one year of your life?
Of course, these calculations are based on historical returns and may not reflect actual market conditions in the future but at the very least they are educated estimates.
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What is the downside to reinvesting dividends?
So far, we have only looked at the potential upsides of reinvesting your dividend earnings but are there any negatives associated with not having your dividends paid out? As with most things in life, there are pros and cons and I’ve collected a few downsides to dividend reinvestment here:
- Reduced Cashflow: When reinvesting dividends instead of considering them as earned income you are effectively inhibiting the growth of your active cash flow. This can be disadvantageous if you have ongoing expenses or debt that needs to be serviced (such as a mortgage).
- Delayed Gratification: Don’t underestimate the psychology of money! Having dividends paid out on a monthly or quarterly basis can tremendously boost your attitude towards investing and help keep you on track.
- Less Diversification: This point really depends on your broker and setup. If you are using a DRIP to reinvest your dividends, these dividends will flow into the same company that paid them out. This can lead to an imbalance in your portfolio if a single stock consistently pays out higher dividends than others.
While the last point is not really a downside of dividend reinvestment it is something to keep in mind. Luckily, the solution is simple: rebalancing. By rebalancing quarterly or annually you make sure that no single stock or fund commands a large percentage of your portfolio (this does not hold true for total market funds such as VTI, VOO, etc.).
Conclusively, reinvesting dividends is in almost all cases a good idea to increase your wealth and riches over time. Can it make you rich overnight? Certainly not. But setting up a dividend reinvestment plan will certainly pay off in the future, even though you will need to delay the gratification of passive income just a little longer.
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To see all of my most up-to-date recommendations, check out the Recommended Tools section.