Amassing a fortune doesn’t typically happen overnight. Building wealth takes time.
Sure, you can make a quick buck by winning the lottery, timing a stock trade just right or flipping a house. There’s no crime in turning a quick buck, but we all know Aesop’s old fable: slow and steady wins the race.
Warren Buffett, widely regarded as one of the world’s most successful investors, once wittingly remarked, “Our favourite holding period is forever.”
His clever quip rings true considering that over the past 70 years, his commitment to long-term investing has turned $6,000 into nearly $70 billion.
Buffett made his fortune from conducting extensive research to find the right companies in which to invest, and then hanging onto those investments for the long haul; however, his most important investment strategy was to reinvest profits back into those businesses.
The simplest reason to invest for the long term is also the most compelling.
Compounding your returns
Compounding is the process of making money on reinvested profits. The more you reinvest, the more you can potentially earn. Think of it like a money snowball rolling down a hill and continuously growing.
To demonstrate how compounding works, let us look at a hypothetical example. The graph accompanying this article shows how an investor’s decision to participate in a reinvestment program can significantly impact the long-term value of their investment.
In this example, the results are depicted in the graph.
Here we have three investors who placed $25,000 in the same investment, but chose three different levels of participation in the Dividend Reinvestment Plan (DRIP) program.
Investor 1 decides not to participate in the program. Investor 2 decides to reinvest 50 per cent, while Investor 3 chooses to reinvest 100 per cent of their distributions back into the investment.
As we can clearly see in the graph, the value of each investors’ portfolio appreciates at a different rate, with Investor 3’s investment growing the fastest and Investor 1’s growing the slowest.
Notes: The example assumes a five per cent annual dividend payout and an 11 per cent annual growth rate for the underlying investment. The growth rate is based on the average return realized by the MSCI/IPD Canada Property Index from 1985 to 2019.
Remember, all three investors purchased the same investment; the only difference is the degree to which they reinvested their distributions back into their investment.
By the end of 10 years, Investor 3’s investment would be worth 28 per cent more than that of Investor 2, and 64 per cent more than Investor 1.
Accumulating wealth is not something you do for a short stretch of time, but rather it is a life-long pursuit.
So the next time you are making an investment and have to decide whether to reinvest your dividends by participating in the product’s DRIP program, remember that the real game-changer is compound interest and its ability to build wealth throughout your life.