"It is the greatest mathematical discovery of all time."
-- Albert Einstein on compound interest
Indeed, there's nothing like the feeling of having compound interest work for you. Consider: Were you to earn 10% annual returns on a $10,000 portfolio you would double your money in seven years. Ratchet up the return to 15% and you'd see a double in five years. Raise it again to 17.29% -- the average annual return for Mathew Emmert's Motley Fool Income Investor -- and the double comes in four years. That's all thanks to the magic of compounding.
There's also nothing like the dread that comes from compound interest working against you. I'll never forget what it was like when we were $45,000 in debt. Back then, we were set to pay more than $8,000 in interest in a single year.
You get the point, right? Interest can be free money that can work on your behalf, or an unsightly burden that makes everything you buy more expensive. Smart investors seek interest rather than pay it. But over time, the best investment of all has proven to be stocks. Yet stocks don't pay interest. Sure, the rules of compounding still apply, but stocks often deliver stomach-churning volatility on the way to higher-than-average annual returns. That simply won't wash for some risk-averse investors.
Fortunately, there's an alternative: dividend-paying stocks. Typically unsexy but nearly always less risky, dividend payers offer regular payouts that, it turns out, look an awful lot like compound interest when the cash gets reinvested. And that can make even seemingly poor investments appear, well, good.
Scandal-ridden beauty of a stock
Consider Bank of America (NYSE: BAC ) . Along with Janus (NYSE: JNS ) , Bank One (NYSE: ONE ) , J.B. Oxford (Nasdaq: JBOH ) , and Wells Fargo (NYSE: WFC ) unit Strong Capital, Bank of America was one of the original firms implicated in the mutual fund scandal at the end of 2003. It settled the charges laid against it by New York Attorney General (and now gubernatorial candidate) Eliot Spitzer for $675 million.
Normally, we'd advise you to stay away from any scandal-tainted stock. But what if, a decade ago, you saw a growing bank that seemed to be sprouting up new locations everywhere? What if you thought that the stock traded for a reasonable multiple to earnings, and was bound to benefit from what appeared to be an improving economy? What if you had decided to invest and dollar-cost average in new money each year, beginning in February 1995?
$20,000 on $2.75 a day
It turns out you'd have done pretty well. I took a hypothetical investor who plopped down $1,000 each year right around March 1, close to Bank of America's regular first-quarter ex-dividend date. All dividends were reinvested, and all shares granted as a result of stock splits (there were two) were held. Have a look at the results:
2-for-1 stock splits occurred on Feb. 28, 1997, and Aug. 27, 2004.
Minimal, regular investments would have created an 87.4% return over the course of a decade. And by minimal I'm talking about roughly $2.75 a day, or half the price of that deli sandwich you just bought for lunch. (Think about that the next time you go to pitch some leftovers in the trash bin.)
Also, consider what happened during the decade we're talking about. You'd have held Bank of America stock during some pretty trying times. From the stock market bubble to the fund scandal, the bank's shares were tainted at differing times over the past 10 years. The dividend payouts, however, would have made sure that the position never dipped below the principal invested.
Even better, the original investment would now be generating more than $800 in annual income for an effective yield of 7.4%. (Bank of America's current yield is 3.9%.) By reinvesting the checks, you'd have earned the right to more shares, and a higher payout, just like with compounding interest.
And did we mention it's free?
The best part of dividend reinvesting is that it usually costs nothing. You just buy more shares on the company's dime. That's free money, Fool. And there are plenty of brokers out there who will help you claim it. For example, I checked with each of the brokers profiled in our Broker Center and found that all but one offer clients the facility to reinvest dividends. One, ShareBuilder, even reinvests dividends automatically. The lone holdout was BrownCo, a unit of JP Morgan Chase (NYSE: JPM ) .
I'm not one to contradict Einstein, so I'll grudgingly agree that compound interest is indeed the greatest mathematical discovery of all. But, as an investor, I'll put reinvested dividends as a close second. After all, free moolah is free moolah. How often does an offer like that come up without an unexpected visit from Ed McMahon? Not very.
But even if you don't reinvest the payouts, investing in dividend-paying stocks has proven over time to be a market-trouncing strategy. It has certainly worked that way for Income Investor subscribers, who are seeing the newsletter selections outpace the S&P 500 by nearly 7% without reinvesting a dime. You're invited to get in on the action at zero upfront cost. Nose around free for 30 days and, if you like it, hang out. We'll stick it to the market together.
Fool contributorTim Beyersis a huge fan of dividend-paying stocks.Tim didn't own stock in any of the companies mentioned in this story at the time of publication. To see what stocks are in Tim's portfolio, check out his Fool profilehere. The Motley Fool isinvestors writing for investors.