Compounding is the simple concept of earning interest on interest, and it is one of the most fundamental ways for investors to build wealth over the long haul. In fact, at one point in time Albert Einstein referred to compounding as "the most powerful force on earth."
A Quick Example
If you earn 4% interest on a simple savings account balance of $10,000, then you will have $10,400 in that account at the end of the first year. If you earn another 4% interest on that amount the following year, you'll then have $10,816. In 15 years, you would have accumulated $18,009, increasing your investment by more than +80%.
But compounding works for more than just bank customers. Stockholders can take advantage of it, too, through dividend reinvestment plans (DRIPs).
Many publicly traded U.S. corporations offer Dividend Reinvestment Plans (DRIPs) as a way for their shareholders to acquire additional shares at a very low cost. DRIP plans enable investors to automatically take any dividends paid by a particular firm and invest those funds back into the company's stock, often at a discounted price. In addition, most DRIP programs charge either very low transaction fees, or in some cases no fees at all.
The Power of Dividend Compounding
Over the long run, there's no better way to grow wealthy in the investment markets than to systematically invest in high-quality stocks and funds, hold on for the long haul . . . and reinvest your dividends.
That's why Dividend Reinvestment Plans, or "DRIPs," are such powerful wealth-builders. By plowing your dividends back into more shares, DRIPs make it easy to harness the miraculous power of compounding. The beauty of compounding is that any little smidgen of money you can put to work now -- no matter how small -- can have an extraordinary effect on your wealth down the road.
For example, let's say you're able to stash away $5,000 per year. Although that might not seem like a tremendous amount of money, thanks to the magic of compounded dividends, a $5,000 annual investment can turn into nearly $5.0 million over time.
Assuming a $100 share price, in this example you'd start out at year #1 with an investment of just 50 shares ($5,000 divided by $100). But thanks to the magic of compounded dividends, by the end of this 30-year period you'd have a nice nest egg of 49,736 shares in your brokerage account, and those shares would be worth nearly $5.0 million. Even better, at year #31 those 49,736 shares would be throwing off more than $910,000 in cash dividends each and every year -- that's almost $1 million in annual dividends alone!
Best of all, this example assumes the security's underlying share price doesn't budge over the entire 30-year period -- that it doesn't even gain one single cent. The returns shown above display gains from dividends only. If this security's share price increases in value at just +5% per year, then in this example you'd end up with 39,635 shares and over $17 million in your brokerage account.
How to Invest in DRIPs
The first thing an investor must do is find out which companies have DRIPs. This can be done by searching through financial websites or contacting the company directly. Since DRIPs vary depending on the company, it is important to do your homework before signing up for a DRIP.