If you invest in stocks, you probably love the thrill of buying an undervalued gem that rises 50% in a few months -- or that triples over two years. Who doesn't? It's a great feeling. But it doesn't happen every day. And counting on a big score is no substitute for a well-constructed, diversified portfolio that builds wealth over time.
For most investors, the foundation of a long-term portfolio is a mix of large-, mid- and small-cap stocks that includes some dependable income payers. Dividend-paying stocks tend to be less volatile, and the income they generate provides ballast to a portfolio that also includes more aggressive offerings.
Dividend reinvestment is a common practice in retirement plans for investors under 59½. That's because it allows for no-decision buy-and-hold investing in a portfolio that doesn't allow withdrawals anyway. (Outside a retirement portfolio, it's not a bad choice either -- just remember that you'll have to pay taxes on the dividend amounts, so you'll need to use cash from elsewhere to do so.)
To see why dividend reinvestment is so powerful, consider this example: You buy 100 shares of a $100 stock for $10,000. The stock pays an annual dividend of $5 per share, for a 5% yield at purchase. You reinvest all dividends into purchases of new shares. (For the sake of this example, let's say the share price and dividend don't change, the dividend is paid only once a year, and we won't include commissions or fees.)
As you can see, even with the lamest type of stock -- one that didn't contribute a single penny of share-price appreciation over 10 years, and with a flat dividend to boot -- dividend reinvestment turned your 100 shares into more than 162 shares. In year 10, the dividend yield on your $10,000 investment is now about 7.8%. And your total return is 62.9%.
Now, let's use a more complex but realistic example: a stock with share price appreciation of 5% a year and dividend growth of 5% a year.
Wow! So when the share price and the dividend both increase 5% a year, you end up with about the same number of shares (you're spending more on shares each year, but at an increasingly higher price). And after 10 years, the dividend yield on your $10,000 investment is now a whopping 20% -- and your total return is an impressive 191.3%.
I hear what you're saying: "What about commissions?" And you're right. The above examples don't account for commission costs, which take a chunk out of each transaction and significantly lower long-term returns. But there's a way around this problem: If you use a Dividend Reinvestment Plan (DRIP), you can reinvest dividends without paying commissions. That's why I recommend this strategy only with stocks that offer DRIPs.
DRIPs have another advantage: by automatically reinvesting your dividend whenever it's paid, you end up paying whatever the share price is on that day. With luck, you'll end up sometimes buying the stock when its share price is temporarily depressed -- and when you do, you'll add a greater number of shares than you will on days when the share price is peaking. As a result, over time, you'll benefit from "dollar-cost averaging" -- unless you're very unlucky, your average purchase price over the long term will be less than the stock's actual average price over that span.
Risks To Consider: Automatic dividend reinvestment works best with long-term, buy-and-hold stocks with average or higher yields and steadily increasing dividends. Volatile stocks, or shares of companies that are likely to experience significant changes to their business fundamentals, are less likely to produce strong results over time.
Action To Take: Some solid, buy-and-hold stocks with attractive dividend yields, good prospects for long-term growth and DRIP plans include AT&T (NYSE: T), Boeing (NYSE: BA), Cisco Systems (NYSE: CSCO), Duke Power (NYSE: DUK), Southern Company (NYSE: SO) and Verizon Communications (NYSE: VZ). International Paper (NYSE: IP) and Pfizer (NYSE: PFE), which I recently recommended, also fit the bill.
Editor's Note: Most people think you have to sacrifice growth for income. But we're holding 23 monthly dividend payers... and have seen our portfolio grow 50%. Get all the details here, including names and ticker symbols.