The power of compounding is an undeniable force that can build wealth for investors in up and down markets. Historically, dividend investing has outperformed many other investments over time. The reason for this is that compounding interest from dividends reoccurs monthly, quarterly or yearly. Compounding only reoccurs though, if you are re-investing your dividends. We will cover re-investing dividends in more detail a little later in this article so keep reading…
This compounding interest or re-investing of dividends equates to something called (dollar cost averaging), which allows investors to buy in at a high or low price. Over time, the price in which the investor pays, averages out to a dollar cost average. Another wards, it is a way to gain profits without having to time the markets or worry about buying in at the very lowest price on a asset. It is theoretically, a passive way to invest your money and still get a return, without having to study the financials of the company all the time and worry about if your investment is doing good or bad. Sounds good right?
What is a dividend?
A dividend is a a portion of a company’s earnings that they PAY YOU, for investing your money with them. In most cases, companies pay a dividend to their shareholders monthly, quarterly or annually (once a year). These payout can be in the form of cash that can be paid directly to you or they can be in the form of a stock just for simply owning stock in a company.
If you are looking to invest money with a company that pays a dividend, we would first encourage you to do some research on what types of companies offer dividends. This is important to look into because it can help you save money in taxes at the end of the year on capital gains or profits made from your investment. If you want more information on the types of companies that pay dividends and the tax implications, you can watch the video below.
Does compounding interest protect you from losing money?
An investment that compounds interest for you does NOT mean that you are completely in the clear in regards to risk. There is still risk with any investment, so your still going to want to watch your investment from time to time. It is recommended by most professional investors, to check up on the asset to see how it is doing.
Reallocate money, check the financial statements on the company and do this at least every 6 months to a year. This will help you take PROFITS off the table if you are getting good returns and actually help you keep some of those profits. If the asset is doing bad, it will also allow you to re-examine your investment and sell some of the investment off, to lower your risk, if the investment continues to go down in price.
So many people just (stay in) when they are getting good returns on an investment and think the price is going to go up forever. This is not a realistic approach to investing because the one thing we all know, is that markets go up and down. So if you are up on an investment, take some of the shares and sell them off. Take some of the cash and use it for other things.
The last thing you want to do is get good returns on your stock and think to yourself; “I’ll just stay in 100% because I can get even more returns as the price continues to go up”. Usually what happens to most investors when they do this, is that the price of the stock ends up going down and they lose all their profits they made and even worse, they lose some or most of their principal too.
To answer the question, of “whether or not compounding interest protects you from losing money?” is a difficult one to answer. If we take into consideration that a stock can go completely to zero in price and the company can go bankrupt, then the answer is NO. In most cases you can AVOID being fully invested with a company if you follow the rule for re-allocating money and taking money off the table from profits you make on the asset like we mentioned in the paragraphs above. If you do this and a company does go bankrupt and the price hits zero, you haven’t lost everything because you were able to keep some of the profits.
If we take into consideration the company you have invested in, has good fundamentals and has been around for awhile and has a good track record of paying dividends, then by all means the compounding interest can play a powerful role in protecting your money from losses on the stock price through dollar cost averaging.
Re-investing your dividends!
We have mentioned dollar cost averaging and how that plays hand in hand with re-invested dividends, to give the investor leverage. This is essentially what re-investing the dividend or compounding interest is. Every time you GET PAID by the company, you have the choice of taking the pay out in cash and having it mailed to you or you can buy more stock (re-invest). The intelligent investor will re-invest his payout back into buying more stock regardless of the price. If the price has dropped from where the investor initially bought in at, then the investor is actually getting the same stock at a discounted price.
The more shares an investor buys, the more stock the investor owns and the payout increases. So if the investor is buying back in with re-invested paychecks and owning more stock of a company at a cheaper price, then the passive income from that investment is getting larger. The interest is compounding without the investors emotions interfering with the long term perspective of the investment. It is also a good way for the investor to stay committed to the asset when markets go up and down.
How to get started in dividend investing.
The good news is that anyone can take advantage of dividend investing. If you are considering dividend investing, it is imperative to understand the investment first. You need to know something about reading financial statements, balance sheets, income statements and many other things that are crucial in making a decision to buy a companies stock for dividend income.
For starters and beginners maybe read a book like “All about dividend investing” by Don Schreiber, Jr. and Gary E. Stroik. The more knowledge you have about the investment you are looking at, the better the decision you can make for investing for better returns and passive income that will last.
If you have any ideas or other suggestions for dividend investing please leave a comment below and we will be sure to create future posts on the topic.