Financial compounding is what turns invested cash into real wealth over time. The money you directly invest will only take you so far, but the returns on that money, compounded over decades, can turn someone of even modest means into a multimillionaire.
That's why we launched the real-money Inflation-Protected Income Growth Portfolio with a focus on companies that pay, have increased, and look capable of continuing to increase their dividends. After all, in order for your money to compound, you first have to find a way to generate the cold, hard cash that's going to do all that compounding for you. And there's nothing like a rising dividend to speed that process along.
The power of a growing dividend
Any cash dividend puts money back in your account. As long as you're still in the mode of building wealth, that money can be reinvested in either the company that paid the dividend or in others that also pay dividends. More cash invested in dividend-paying companies means that the next dividend payment will likely be all that much larger. If the companies you own also have the tendency to raise their dividends, then that rate of overall payment growth just moves that much faster.
It's a virtuous cycle, and one that, if you successfully keep at it for long enough, can turn your trickle of investable cash into a gushing fountain of cash-generating wealth. The graph below shows our own household's experience with an investment strategy based on that concept:
All told, we've received higher total dividends each year, thanks to the power of combining:
- New investments
- Dividend growth
- Dividend reinvestment
It's not rocket science, but as the last few years have reminded us, it's not a fire-and-forget-it type of strategy, either.
What could go wrong?
For instance, we were shareholders of Fifth Third Bancorp (NASDAQ:FITB), one of several banks that slashed its dividend during the financial crisis. We bought the bank's stock in part because it claimed "minimal exposure to sub-prime lending", but apparently even that minimal exposure was enough to jeopardize its dividend.
Additionally, we still own shares of General Electric (NYSE:GE), whose financial arm was active in the sub-prime mortgage markets, and losses there forced it to cut its own dividend payment. Fortunately, the company's diversified strength enabled it to carry through and to resume increasing its dividends.
Still, as an investor, you have to manage for that type of risk. There are no guarantees in investing, but what pulled our household portfolio though the financial crisis, and what we're counting on for that real-money iPIG portfolio, is prudent diversification.
Slash + growth = survival
While GE and Fifth Third were stumbling through the crisis, technology titan Microsoft (NASDAQ:MSFT) told a different story. Microsoft managed to raise its dividend in 2007 and 2008, pay higher dividends in 2009 than 2008, and resume actual increases in 2010. Likewise, the absolute value of the distribution we received from pipeline giant Kinder Morgan Management (UNKNOWN:KMR.DL) kept increasing throughout the financial crisis.
All told, in spite of the cut dividends in our financial-related holdings, the majority of our money was tied up in companies in different industries that maintained or even raised their dividends. The growth we received from those companies, the additional income we generated from reinvesting those dividends, and the additional cash we were able to scrounge up more than made up for those cuts.
It wasn't pretty, but as the chart shows, it was effective. Sure, we'd rather our portfolio have been firing on all cylinders, but that would have required a substantially cleaner ability to tell the future than I've ever had. It's also why prudent diversification is a fundamental part of the iPIG portfolio philosophy. Because I don't know what form the next economic meltdown will take or when it will happen, but I'm certain that something will go wrong -- it always does.
When there's real money on the line...
Compounding rising dividends is an excellent long-term way to build real wealth. Still, when there's real money on the line, you have to manage the risks in order to improve your chances of reaping the rewards. It's that balancing act of managing risks while trying to anticipate an uncertain future that makes investing a challenge.
It's also why we structured the real-money iPIG portfolio around the three pillars of dividends, valuation, and diversification. Because until there's a way to get real rewards without taking real risks, those risks will be there and need to be managed. If you're interested in following along as we build and manage this real-money portfolio, watch my article feed for further details and the next picks.
Chuck Saletta owns shares of General Electric Company, Microsoft, and Kinder Morgan Management, LLC. The Motley Fool owns shares of Fifth Third Bancorp, General Electric Company, and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.