WHAT’S BETTER THAN COMPOUND INTEREST?
In this article, we will reveal a compelling reason why holding a stock for the long term is always the best way to make anyone plenty of money.
As usual, we will be using math to show you the proof.…. Well, what’s better than incontestable math and numbers?
Before we show you the calculations, think for an instance, how would an investment into a Certificate of Deposit (or Fixed Deposit) grows in the long term— will it grow in a straight line or will it grow exponentially?
In order for those investments to become ‘compounding’, all of the returns will need to be reinvested. Otherwise the rate of return will stay flat and will not grow. Of course the problem with this method is that you cannot enjoy the money until it has reach its growth target. Neither the principal nor the regular returns. That’s just not fun, isn’t it? Imagine having to wait 30 years for the compounding magic to take effect. But what if there is another way, a better way, to obtain compounding increases without reinvesting the proceeds? As a matter of fact, you can spend the entire dividend if you want, every quarter and every year. Keep on reading to find out.
What if there is an investment which can do both? What if there is an investment which can let the investor enjoy the yearly returns as well as giving an exponential increase for the end of period investment value?
What kind of investments could give such good returns? You may have guessed it, it is an investment into the stocks of great corporations. This is the best way to become rich, by joining as a co-investor into a great corporation, with great ideas and technology coupled with great people. As long as companies maintain their edge in these respective areas, there is no reason for them not to be able to exist indefinitely. Indeed, some companies have prevailed over countless events in their very long life spanning a hundred years or more. Finding this type of company could be challenging, but there are many of them out there. You just have to do some research.
Since a person can enjoy both the exponentially rising dividends and the exponentially higher end of period value as described above, why only a handful of people actually invests in stocks? There are many misunderstanding and confusion about stock investing. Some thought it is only for the rich. Some thought it is too risky. Both are wrong of course. Some understand stock investments and why it is beneficial, but could not explain it well to others. This is where we can help. We explained in our writings and in our articles, why stocks is the best investment for making very good returns. We countered those incorrect facts about stocks and laid them bare. One particular problem with evaluating the performance of stock investments is the profit calculation which can be done in several different ways. In this article, we want to show you an important but routinely ‘missing’ piece which few people understood. But first, let’s get back to the basics. In Book 3 of the 259 Trillion Vs 5 Trillion series, we explained how a stock is valued using Price to Earnings ratio, better known as P/E. For those who want a short version of the explanation, please download the presentation video from this link:
From the presentation video, it is clear that the price of a stock is determined by the profit potential of the business. The more profit, then the higher the price would be. [Corporations that do not make any profits or simply do not want to make dividend payments, their share prices are normally valued by the assets their businesses are holding. One good example of a company whose share price kept on rising but never paid any dividend is Berkshire Hathaway controlled by Warren Buffett. Its price is determined by its assets and holdings.]
From the video, it is clear that the market price of any good (including stocks) is based on the amount of new wealth it will be able to generate for its owner, so now understanding valuations and market values would be an easier task. Typically a P/E of 15 signifies that a would-be owner is willing to pay the existing owner 15 times the yearly return on the money.
We all know very well that corporations grow in size, year in and year out. The revenue as well as the profit will go up because a good corporation is actively engaging in improving itself and the world and hence will be rewarded with ever more demand for its products and of course, ever higher profit. When you think about it, for the same amount of invested money, you will be able to obtain larger and larger returns. This is one unbeatable trait of stock investment that makes millions of people rich.
Suppose that you bought 10,000 shares in company XYZ at a price of $3 a share.
Company XYZ is generating wealth at $0.12 a share yearly which in turns generates $0.12 X 10,000 shares or $1,200 a year on your invested money. The details are shown in the table below:
Now suppose company XYZ sales and therefore income has increased. Its profit is now $0.32 a share. The return you will be getting on your shares would be:
$0.32 X 10,000 shares = $3,200 a year.
Now, this is a very handsome increase for an investor. Check out the changes below:
As one would realize, the higher profit means the investor would reap a higher return although he or she did not add new capital to the investment. The yearly return is now 11% a year on the original invested money. In this instance, what would happen to the stock price? Indeed, it will be pushed up by new buyers willing to pay the market rate for it.
In their eyes, they are paying reasonable price to obtain the market standard of 4% return on the money. To you however, we already knew that your return is higher at 11% per year. Should you want to sell out now, you will make a really handsome profit of $80,000 – $30,000 = $50,000. But if you are a long term investor and would like to stay invested in this great company, you will realize that as the years goes by, your returns will keep on going up and you would not need to add a penny more of additional money.
The following table shows how a steady and good performing company will be able to increase your returns, without requiring you to reinvest the profits.
By the tenth year, you will be getting back every penny of the original investment made and by the fourteenth year, you will be generating a constant 24% return per annum on your invested money. The dividends paid are yours to spend as you see fit. In this instance, the increase of the dividends is exponential. Where can you get an investment vehicle out there, paying you a constant 24% return a year on the money? History shows that some companies were able to increase their dividends, much higher than the example shown above. Perhaps in another 10 years time, that company would be paying you a yearly return of 40% on the money. That’s 40% every year! This is the best way to be rich!
Here is an interesting example on why owning a stock for the long term is best (provided you own a great company that is). We tracked the performance of Intel, the leader in the microprocessor world. Upon its IPO if one purchased 1,250 shares worth $25,000, what would happen to the investment today? If you purchased Intel then, your $25,000 would worth $51.6 million today, and your 1,250 shares would become 1.5 million shares. Check the table below and look for the yearly returns after a very long time.
Yes, the annual return to the investor is now worth 1.36 million dollars a year, for a return of 4,556% a year, every year on the original money! The investor is free to take out these dividends every year without diminishing his or her future dividend payments. And the best of all, it can continue to go up every year, compounding exponentially. Not just you can have your cake; you can certainly eat it too!
Imagine that after a few years, you will collect more than your entire invested capital, every single year! Not just you will earn more every year, it also continuously grows bigger every year. This is a great way to earn higher on your ‘deposit’ or your capital, without doing anything else. The collected dividends can be deposited into other good yielding instruments if you wish to supercharge your returns, or just simply deposited into boring, low yielding instruments with minimal risks. The choice is yours to make.
A retiree, who invested his or her money into great stocks, will be earning great dividends every year, despite withdrawing the dividends for living expenses. Even if all of the dividends are withdrawn, the investment value will not come down at all, in fact it would go up. A retiree who follows the 4% withdrawal rule will realize that his investment value will keep on going up, in essence enabling a higher withdrawal rate. For example, a retiree who invested $625,000 into the stock market to enjoy the yearly or quarterly dividends, will realize that in 13 years, the money would grow to a million dollars instead while he or she enjoys the dividends worth as much as $375,000 in total. If we assume a market correction of 10% once every five years, the invested money would still grow to $749,000 from $625,000. Even if we assumed a higher, 15% market correction occurring every 5 years, the money will still last the retiree by a remarkable 98 years or so later, before running out, all the while keeping his yearly return the same every year. It is more likely that the investor would die before the money runs out, leaving some for the heirs. Now, when people talked about stocks to be “risky”, they were talking about something that is not really backed by real data and facts. They fell prey to the sometimes wild dance in the stock market (which can psych out anyone to think that stocks are not safe), failing to understand investors investment horizon and the companies actual long term underlying performance. (For scientists and engineers, this means one is missing the ‘climate’ for the daily gyrations of the weather).
The stock market can be downright demoralizing if you want to make a quick buck. Stock that rises too quick without any underlying growth and products to support it, could go south very fast, without much warning. If you want to play around with the rise and fall of the daily price in order to game the market, then take note that we have conducted a major study on the long term profit of just such a venture. We compared the performance of a long term investor with a buy and hold strategy and one that would buy and sell at the opportune times. The study shows that long term investors (investing in company whose products are trusted and with good governance), win hands down. Unless an investor have the gift of foresights and an extraordinary research capability, normally it is not possible to beat the buy and hold strategy. Check out those articles for your reading pleasure.
For other types of investments such as bonds, their returns can be more difficult to judge and potentially riskier too. For example, we think buying and holding bonds can be pretty risky. Try performing the same calculations as above, but for bonds and you will see the problem.
Now we hope that you will understand exactly why buying dividend paying stocks works great for so many people, including retirees!
As a final note, whether an investment you make will turn out to be making good profit for you, just imagine the joy you would experience in owning top companies that you are actually proud of, owning shares in companies that are trying to make life easier for everyone, companies that are providing valuable services for all. It is a very good feeling to have, even if the market is down! Gold? There is no pride in it, only ignominy, so don’t even think of buying it!
**For the above calculations, inflation is not an overriding factor and has no impact to the end result as explained at length in our books.
SHARIF RAHMAN & AMY NORWOOD