Dividend Snowball: Building Predictable Cash Flow

Key Points

• The dividend snowball effect occurs when you reinvest the dividends you receive over a long period of time.

• Instead of taking dividends in cash, you use them to buy additional shares, which in turn result in more future income.

• If your goal is to build a large, predictable income stream before retirement, dividend compounding could be a good strategy.

• These 10 stocks could mint the next wave of millionaires ›

Dividend stocks are often thought of as income instruments, and they certainly can be. Many retired investors derive a significant portion of their income from dividends, and there are lots of stocks with excellent track records of consistent dividend payments over decades.

However, dividend stocks can also be excellent compounding instruments, especially for investors who still have many years until they'll rely on their investments for income. If this describes you, it's important to learn about the dividend snowball effect and how it can help you build a much larger income stream over time with minimal ongoing effort.

What is the dividend snowball effect?

The dividend snowball effect refers to the growing income stream that results from the automatic reinvestment of dividends in additional shares.

As a very basic example, let's say that you own 200 shares of a stock that trades for $50 and has a 5% dividend yield. Your investment would be worth $10,000, so your 5% yield would result in $500 in dividend income over the first year. But instead of simply taking the cash, these dividends would be used to buy 10 more shares at $50 each, leaving you with 210 shares at the end of the year. Now, you have 210 shares, all of which are paying you dividends, and each year you use this method, the number of shares, as well as your income, will grow.

Over time, the dividend snowball effect can produce a surprisingly massive income stream, as we'll discuss in the next section. This is especially true if you buy stocks that have a strong track record of increasing their dividends over time.

An example of how this works

We're going to keep the numbers simple for illustration purposes, but here's an example of a dividend snowball and its potential.

Let's say you invest $10,000 in a portfolio of dividend stocks that pay an average 5% dividend yield. So, in the first year, you'd receive $500, just like in the prior example. Furthermore, we'll assume that the stock price increases by 5% in the average year and that the company increases its dividend payout over time to maintain a roughly 5% yield.

Data source: Author's own calculations. All numbers are rounded to the nearest dollar.

The column on the right shows the dividend snowball effect in action. Of course, not everyone has a 40-year time horizon until they'll need to start relying on dividend income for day-to-day expenses. But even after a 20-year holding period, the dividend snowball effect would have increased the investment's income stream by more than 570%.

Supercharging the dividend snowball

As I've discussed, the concept of the dividend snowball involves passively reinvesting your dividends in additional shares of stock. And this alone can result in your income stream multiplying several times over the long run.

However, the key to truly leveraging the long-term income compounding effect is to continue investing over time. Most modern investment platforms even allow you to set up an automatic stock purchase at regular intervals.

If we use our example above of a $10,000 investment in stocks that yields 5% and whose stock price grows by 5% per year on average, but then add $5,000 per year to our investment, it would result in a much higher income stream. In this case, here's what the growth chart would look like:

Data source: Author's own calculations. All numbers are rounded to the nearest dollar.

Of course, real-world math isn't likely to be this simple. The stocks you buy aren't likely to have the same dividend yield year after year, nor are they likely to increase in price in a linear manner over time. But the concept still applies, and the compounding power of dividend reinvestment, combined with consistent investing, can be an excellent way to build wealth and predictable income over time.

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Dividend Snowball: Building Predictable Cash Flow was originally published by The Motley Fool