Generating a passive income from shares is usually discussed as a strategy for income investing. But there’s no law that says we have to withdraw dividends.
By reinvesting my dividends and targeting growth businesses, I’m using a passive income strategy to build wealth for my retirement. As I’ll explain, I reckon this is a powerful technique that could deliver impressive long-term gains.
The magic of compounding
Withdrawing dividends can be a good approach for income, but it’s likely to limit portfolio growth. When we withdraw a dividend, we’re effectively taking away part of our investment capital.
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Personally, I’ve never withdrawn a single dividend from my portfolio. I’m still working, so I want to build up my holdings as much as possible.
I use all of my dividends to buy more shares.
In turn, these shares generate additional income for me, which I then use to buy even more shares.
This approach is known as compounding — reinvesting previous income to generate more income in the future.
Compounding is a powerful growth technique over long periods. But it doesn’t necessarily deliver much share price growth. For that, I rely on a second technique.
How I target share price growth
A dividend represents a share of a company’s profits. What’s left can be reinvested in the business or used by the company to strengthen its financial position.
I look for companies that can reinvest their retained profit successfully, so that their profits continue to rise.
In turn, this normally leads to steady dividend growth. And when the dividend rises, very often the share price does too.
One rule of thumb I use is to add a stock’s dividend yield to its forecast dividend growth. The result is the expected total return from a stock over the coming year.
This approach is based on the assumption that if a company’s dividend is increased, its share price will rise by an equal amount, so that the dividend yield remains the same.
Obviously this doesn’t always happen, at least not from year to year. There is no formal link between dividend payments and share prices.
However, over long periods, my experience suggests that it is a reasonable approach.
One example of this is FTSE 250 baker Greggs. Over the last 20 years, Greggs’ dividend has risen by an average of about 11% per year.
Over the same period, Greggs’ share price has risen at an average rate of 12% per year.
Obviously this share price growth hasn’t happened in a straight line. But it has happened.
Making a million
I reckon that if I can invest in dividend growth stocks at attractive valuations, I should be able to achieve a long-term average return of 10% per year.
At that rate, how much would I need to make a million?
If I invested £20,000 today and then added £200 to my portfolio every month, my sums suggest that I could reach £1m in 33 years, based on a 10% annual return. Of course, I might not achieve that return and could even lose money.
But the beauty of this strategy, if successful, is that when I’m ready to start drawing an income from my portfolio, I don’t have to change anything. All I’ll need do is start withdrawing my dividends, rather than reinvesting them.
