How do you generate wealth through compound growth investing?
The concept is very simple but the application through long-term dividend growth investing can be difficult until the steps are broken down. The wealth triangle guide should help you understand how to build wealth systematically.
Investing is simple in concept but yet, so many struggles with investing and generating the return on investment to meet their goals. Compounding your wealth is simply a matter of having your money continuously work for you at the best rate you risk appetite can provide.
Do you let Mr. Market do the compounding for you? or do you take it into your own hands to have a say on how fast you can compound your wealth?
Your risk appetite is a very important aspect of investing that you need to settle on early. If you don’t want risks, you accept getting lower returns and it’s a very important decision as it can ensure you don’t make emotional investing decisions at a later point. In general, you can look at a risk matrix like the below one to establish a range of performance. It is a gross approximation of risk analysis but it does represent the ranges associated with investment safety.
Got a rate of return expectations in mind?
Write it down, we will use it later on. It is acceptable that you may want different risks for different amounts in your portfolio. Overall, you will get a blended rate of return. The blended ROR is what you want to track.
Back to the investing concept, it is simple to comprehend investing but the execution is much harder to achieve the results you want. I will break down the investing challenge with the following 3 pillars defining The Wealth Triangle:
- Time Pillar- Continuously Stay Invested
- Savings Pillar – How Much Can You Invest?
- ROR Pillar – Your Compound Growth Ability – How well are your investments working for you?
Time Pillar – Continuously Stay Invested
The word ‘continuously’ is used on purpose as it is crucial when investing that you stay invested. Time is the biggest factor in compounding wealth and starting early (or now) is the single best decision you can make. Look at the numbers below to see how well time does for you.
With only $10,000, you can have $1,000,000 after 60 years.
As mentioned, if you start with $10,000 and no additional investments, it would take you 60 years to reach $1,000,000 with an 8% return. This is more than achievable. If you read Grace Groner’s story about her investments in Abbott Laboratories (NYSE:ABT), you can see how any hard working employee can achieve financial freedom.
Grace Groner built a $7 million estate from purchasing 3 shares in Abbott Laboratories for $60 each back in 1935. For 43 years, she let her investments compound and the dividends were all re-invested.
What if you simply add $1,000 every year with the same rate of return, you can reach $1,000,000 after 50 years. Time is not something you can control but as you can see you can easily control how much you can invest. Use the rate of return that you jotted down earlier in the spreadsheet below and see where you land with your current portfolio size.
Nowadays, discount brokers and financial firms have to disclose your rate of return so you can use that as a starting point or make your own portfolio tracker to calculate your portfolio or account rate of return.
At this point, you can figure out your magic numbers to The Wealth Triangle.
- Time Pillar: How long do you have for your money to be at work. You do not control this variable, it’s out of your hands. The clock ticks and will keep on ticking. This variable depends on the other two variables.
- Savings Pillar: Your ability to save and manage your personal finance will dictate how much you can invest. The more you save, the more you can put to work. This variable is important but unrelated to investing. Even $100 per year can make you reach the millionaire club 1 year faster. Try it out in the spreadsheet and plug in your numbers.
- ROR Pillar: The return on investment your investment decision provides. Unless you invest in fixed income, bonds or GICs, your rate of return is not really known and is a reflection of your investment decisions.
The Wealth Triangle is a formula where your savings and the compound rate of return tells you how long you have to reach your goal.
Mistake to Avoid – Don’t Wait on the Sideline
Waiting on the sideline for the markets to pull back isn’t a winning strategy. You may think that you are waiting to buy low to profit later on but the market value is a daily voting machine against all the stocks in the market. It’s not a way to assess if you should be invested or not.
Each company trading on a stock exchange has a value that should be evaluated independently of the markets. In my experience during the high and lows of markets, there are always opportunities. In a well-diversified portfolio, you can usually find an opportunity as many companies (like sectors) have different business cycles.
Markets go up over time. Even after a pull back, the market will get back up and keep on going. If you waited on dips to invest, you would wait years between the dips.
Keep in mind that stock prices are not an accurate reflection of a company’s performance. Unless you are very intimate with the company’s finances, a good pair of metrics to watch is the EPS and dividends – more on that later.
In the short run, the market is a voting machine but in the long run, it is a weighing machine.
Savings Pillar – How Much Can You Invest?
As mentioned earlier, the amount you can invest really depends on your ability to save. My hope is that the spreadsheet can help you understand the impact of doing small amounts every year. All you need to do is figure out how you can increase that amount without impacting your life negatively.
What I can do to help is show you scenarios on how to approach pay increases to control your lifestyle inflation. The rest is in your hands and I won’t go into being frugal and all that … Lifestyle inflation and entitlement expectations are personal finance killers.
Salary Increase Example
Here is how someone’s salary can look like over time. As you can see, it doesn’t go up super fast and we can probably expect a few promotions during that time depending on how driven you are. For the scenario, we will have the salary increase by 1.5% annually and three promotions of $5,000 every 7 years.
Now that we have established the income over time, let’s look at the savings we can apply. If you have read The Wealthy Barber by David Chilton, you would start with 10% automatic saving by paying yourself first. Let’s use that as a base line. If you do less, consider reaching 10% first and then figure out how to go over.
10% Annual Saving Rate
With a fixed 10% annual saving rate, your contributions will slowly increase with your annual raises and it’s better than nothing but is that good enough? Use the number in the spreadsheet and assess for yourself.
The numbers below are based on the salary outlined above. The million dollar club is achievable within 34 years. What the below numbers don’t show are any curve balls thrown your way such as buying a home or having children. They do affect the saving rate so it’s important to plan for them.
Growing Annual Saving Rate
What if you could increase the saving rates? How about increasing the percentage at every promotion you get?
You have lived without the extra money for a number of years, take the opportunity to save all of that new money. That’s what I have done and it has worked wonders with my ability to save more.
As you can see below, you can reach the million dollar club 6 years earlier. The extra savings can pay for your children’s education. You end up with an extra $773K in your portfolio. It’s a significant amount if you can avoid a lifestyle inflation.
Mistake to Avoid – Not Leveraging Company Matching Contribution
I hear too often from co-workers that they are not leveraging their employer’s contribution and that’s throwing money away. If your company has a plan to provide a matching contribution to your RRSP or a stock purchase plan, you need to find a way to participate. It’s free money while you are employed.
In the graph above, imagine you are now adding an annual contribution from an employer by the amount of $5,000 since they could be matching your own RRSP. Previously, you reached the million dollar club 6 years earlier than the 10% saving by using your promotions.
With the matching contribution, you can reach it 3 years faster and become a millionaire after 25 years. Imagine what a two income household can achieve, even before starting a family.
Rate Of Return Pillar – Your Investments Matter
You can’t really choose your rate of return when investing in stocks.
But you can choose your investment strategy that supports your rate of return goals – this is based on your risk assessment initially estabished. (i.e. don’t expect stock market returns with no risks.)
This is where compounding wealth becomes a little harder but fear not, there is a systematic way to approach investing to build wealth. I have found dividend growth investing to be an excellent strategy. With rules, such as my 7 dividend investing rules, it can be easier to find a stock to invest in.
REITs, or high-yield stocks, can provide you with a comfortable rate of return as they usually pay a lot of their earnings through dividend or distribution but you will have very little stock growth and the yield is usually below what dividend growth investing can do for you.
Take, for example, Canadian National Railway with a dividend yield of 1.5% versus Choice Properties REIT with a distribution yield of 5%. CNR has outperformed CHP.UN easily and has outperformed the TSX index.
To avoid putting all of our eggs in one basket and mitigate stock market risks, it is generally recommended to diversify by sector and the amount of diversification you do is very important.
I grew my portfolio to 40 unique holdings at some point and I am now down to 30 holdings. I invest in many sectors and recently dropped the basic material sector. One rule of thumb I have is to have no more than 5% in one company so that means I will have at least 20 holdings and I will aim to hold at least 2 per sector.
Your risks profile is yours only but you need to understand that the less risks you want, the lower your rate of return will be. When you plug in your rate of return in the spreadsheet, you can see the compound growth results and decide if it satisfies your goals.
If you opt to keep the rate of return and your timeline doesn’t work, all you can do is save more which is also an option as seen above. The wealth building triangle is simple and it all has to work together to achieve the results.
What rate of return should you aim for? The stock market average is pegged at 8% which is acceptable. For any 1% over the market average you want, you will need to invest time and effort in researching stocks and learning about the companies in more details.
For an investment to provide you with a good return, it needs to make a profit and grow. If it does, it will generally pay an increasing dividend and maintain a consistent dividend payout ratio. If the dividend rate increases faster than the earnings, you would see a higher dividend payout and it’s a warning sign.
A strong company that holds a competitive advantage will usually see growth. More so when the barrier of entry for new competition is prohibitive. Think of the railway companies here, could anyone decide to start a new railway tomorrow? Very unlikely and that gives the railway companies an oligopoly. Find businesses with oligopolies and you usually have a competitive advantage.
Having established how dividend can help establish patterns with revenue and management decisions through dividend growth, dividend payout ratio and EPS, investors can leverage lists of dividend stocks matching various criteria. I see all of the lists below as a starting point.
A dividend king is a dividend paying company that has paid and increased its dividend for 50+ years. There are just 17 dividend kings. It’s an impressive achievement but which is better, a company that has paid a dividend for 100 years without a fault or a company that has increased it for 50+ years. It depends is the answer as past performance is not indicative of future results but we can certainly consider it.
Hormel Foods Corporations (NYSE:HRL) has a compound dividend growth rate (CAGR) of 15.27% over 10 years while Consolidated Edison (NYSE:ED) has a dividend CAGR of 1.54% for the same period. Both are dividend kings but with different dividend growth rates. As you can see just selecting a dividend king doesn’t lead to the rate of return you would want.
A dividend aristocrat is a dividend paying company that has paid and increased its dividend for 25+ years. There are only 51 aristocrats across the S&P index. If you were to have a portfolio of 20 stocks, you could possibly choose your holdings from this pool and build a diversified portfolio.
The same different dividend CAGR can be found with the aristocrats’ list. Again, not all dividend growth stocks grow their dividends at the same rate.
The dividend achievers list requires 10 years of consecutive dividend growth and it opens up the list by a significant amount. New technology companies can soon be found on the list. This is the filter I like most for the following two reasons:
- 10 year is recent enough to reflect current management skills and goals
- 10 year has usually seen a full market cycle to highlight if the company can do well in good and bad times.
Canadian Dividend Aristocrats
Unfortunately, the Canadian dividend aristocrats rule differs from the US rules above where only 5 years is necessary and it has a forgiving rule where you can maintain a dividend rate for 1 year once included.
There are currently 87 canadian dividend stocks and REITs in the list with the same dividend growth disparity as the other lists.
Additional Dividend Investing Metrics
Using the Chowder Rule, you can establish a growth rate you want to have for your investments. It’s based on historical data, and while we know it cannot predict the future growth, companies exhibiting consistency will usually be in the ballpark. This is where the extra research is needed as you need to understand if there is an earning anomaly or if consistency is present.
I prefer to use 10 years of data for the reasons I mentioned above with the dividend achievers and it’s not easily accessible data unless you spend time reading financial reports. Dividend Snapshot uses 10 years of data points to provide over 30 metrics on Canadian Dividend Stock and REITs. With a 3-year, 5-year and 10-year historical averages for dividend growth, payout ratios and EPS, we can establish consistency.
My process looks for the dividend achievers, Chowder score and the consistency to select a stock. So far, it has allowed me to build a portfolio with a 13% return over the past 9 years across US and Canadian stocks.
The Wealth Triangle Guide Summary
Time cannot be controlled but it is the most critical to your wealth. Start early and you will reap the benefits.
Increase your savings to contribute the most you can to your investment portfolio. Avoid the lifestyle inflation whenever possible and leverage your company benefits.
At last, make appropriate investment decisions to support the ROR you want and the compounding table should match your goals. It’s not easy to select investments and that’s why I spent time building a comprehensive list of dividend stocks with 10 years of data. I could not find any services for what I needed and took control of my investment decisions. If you are interested, you can build your own, or you can get a head start with the Dividend Snapshot lists (Dividend Stocks or REITs).