Income stocks are the backbone of my portfolio. These shares provide me with regular, although not guaranteed, dividend payments.
By investing in companies with reliable and sustainable dividend yields, I could create a passive income stream that will, hopefully, last for the long run.
However, as I’m working, I don’t necessarily need that passive income now. Instead, I reinvest that money as part of my strategy for long-term gains.
Compound returns are central to my strategy to generate wealth in the long run. This is the process of earning interest on my interest. And the longer I do it, the more I earn.
For example, if I were to invest £10,000 in a stock offering a dividend yield of 5%, like Lloyds, I’d expect £500 in the first year.
And if the stock keeps its dividend at 5% and I keep reinvesting my chunk of its payout, I could expect my £10,000 to be worth £27,000 in 20 years. That’s the power of compounding.
In fact, if I were to reinvest my dividend for 30 years, I could expect more than £47,000.
However, let’s talk about drip-feeding. If I were to start with £20,000 and invest in dividend stocks yielding 5% a year, while adding just £300 a month, after 40 years I’d have around £600,000.
But this latter amount doesn’t take share price growth into account. Based on previous performance, I’d expect the FTSE 100 to be five-to-seven times larger in 40 years than it is today. Using some rough calculations, I’d predict that £600,000 could actually be worth £2.4m.
Buying the dip
While the general trend of the FTSE 100 is upwards — the index is approximately seven times bigger today than it was 38 years ago when it launched — buying during dips can propel my portfolio forward.
That’s why I’d start buying now. The index might be pushing towards 7,500, but there are many sectors that are underperforming. In truth, the FTSE 100 has been hauled upwards by surging resource stocks.
So, by investing when the market is underperforming, I can hope to supercharge my gains going forward.
If I’m investing in dividend stocks, I need to choose wisely. While a big dividend can be attractive on face value, it can also be a warning sign. Big dividends are often unsustainable, so I need to do my research.
The dividend coverage ratio is a metic used to explore how sustainable a yield might be. It highlights the number of times a company can pay shareholders the stated dividend using its net income.
A dividend coverage ratio of one might be a cause of concern as it suggests that a firm only just has enough profits to fund its dividend programme. Instead, I prefer to look for a dividend coverage of closer to two. That should help me reduce risk levels.
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James Fox has positions in Lloyds Banking Group. The Motley Fool UK has recommended Lloyds Banking Group. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.
Motley Fool UK 2022