Dividend stocks have a reputation for being a safe and steady stream of passive income. And while these stocks aren’t known for their millionaire-making characteristics, given sufficient time, even a boring portfolio of mature businesses can help build impressive levels of wealth.
In fact, receiving £20 in dividends each month could be all it takes to kick off the compounding process that can snowball into a £1m portfolio. Here’s how.
The power of reinvesting dividends
Arguably, one of the best ways to kick-start an investing journey is with an index fund. They require little knowledge to manage, and all the hassles of portfolio construction become irrelevant. In the UK, the FTSE 100 is one of the most popular destinations among index investors when dividends are the priority.
Historically, the index has delivered a yield of around 4%. Therefore, assuming this trend continues, if I were to invest £500 a month for a year, I’d end up with the £20 a month passive income stream by the start of 2025. So how can I turn this into a £1m portfolio?
I need to do two things:
- Ensure my investment account is set up to automatically reinvest any dividends received.
- Continue to drip-feed £500 a month.
By combining a steady stream of fresh capital and using any dividends received to buy more shares, my passive income will start expanding. It will be slow at first.
By the end of the second year, the dividend income will grow to around £43.20 a month. But, over time, compounding accelerates. After about a decade, the monthly income will sit at around £305, then £982 after 20 years, and £2,484 after 30.
While this is going on, the size of my portfolio is still expanding. And after 34 years of continuous reinvestment, my portfolio will surpass the £1m threshold. For reference, if I didn’t reinvest dividends, this journey would likely take more than 50 years to complete!
Risks and expectations
Index investing may be a proven way to build wealth. However, when producing forecasts of future portfolio value, historical returns are far from guaranteed to repeat. As such, the journey to a million may end up taking considerably longer than expected.
This is where stock picking offers a potential solution. When executed prudently, a stock-picking strategy can deliver far better returns than an index fund, even when focusing solely on dividend shares. By being more selective, a portfolio’s yield can realistically be pushed up to 5%, or even 6%, without venturing into overly risky territory.
While a 2% difference may not seem like much, when compounded over decades, it can cut years off the waiting time. Of course, these higher potential gains come with several caveats.
Stock picking is generally far riskier than index investing. And it demands far more discipline and due diligence. Don’t forget a badly built portfolio can easily backfire and end up harming an investor’s wealth.
Nevertheless, it remains my preferred strategy as the higher potential returns make the extra risk worth taking, in my opinion.
