Today I thought I’d share a fun tool used by investors to quickly work out either:
The number of years it takes to double your investment at a given percentage return,
Or the percentage return required to double your investment in a given number of years
The Rule Of 72 is not precise, but it’s good enough in most scenarios.
To work out the number of years it takes to double your investment, divide the number 72 by the annual percentage return of the investment.
For example, an investment with a 15% annual ROI takes (72 / 15) ~5 years to double.
The Rule Of 72 can also be used to calculate the number of years to double your investment.
For example, to double your investment in 5 years you need to get (72 / 5) ~15% ROI.
Personally I don’t know anyone who uses the Rule Of 72, because the results are easier to remember than doing the maths, and any seasoned investor knows these numbers well anyway.
The Rule Of 72 is a fun tool, but be aware that it does become inaccurate beyond rates of return in a specific band. I’ll leave it to someone else to work out what those rates are, and post them in the comments below.
I thought it might be useful to graph the difference between a hypothetical company paying a large dividend that doesn’t grow compared with a hypothetical company with a small, but growing dividend. I’ll be looking to answer these questions:
How much annual growth (percentage) is required for a small dividend to overtake a large dividend?
How much time does it take for a small growing dividend to overtake a large dividend with no growth?
How long does it take to amass more money from the smaller, growing dividend?
This first graph shows the total return over time for companies with no growth, if you were to reinvest their dividends in full.
In contrast, the following graphs show the same thing, but if a company where to have a lower initial dividend return in the first year, but experience growth in the following years. The first graph shows an initial dividend of 1%, the second shows 1.5% and the third shows 2%.
Note: The following 3 graphs use a log scale because the growth was too big to fit on a chart with a standard scale.
As you can see, depending on your timeframe, you may be better suited to either a higher initial dividend with no growth (accepting that this will never make you rich but will get you more money in the short term [excluding profit from the sale of the stock at the end of your investment period]), or a high growth stock with a lower initial dividend (giving you less dividends in the short term).
I apologise, the log scale makes it very hard to compare. Looking at the data, it seems to me that if your investment period is less than a decade, and you’re only interested in dividend income, then you’re better to take a high paying dividend stock (5% after tax or more).
If your investment period is over a decade and you don’t mind not having much income from the investment for the first decade and a bit, then you’re better off taking the growth stock – especially if your investment period is closer to 20 years, because this will pay off very, very well.
Of course, if you don’t need the income and your investment period is less than a decade, you’re probably better off going for the growth stock and selling it to make more money.
If you are approaching retirement and need an income in future, but not immediately, this graph might help you reach your dividend income goals and get rich with the longer timeframe. This graph shows the dividend growth over time (relative to initial purchase) for a growth stock on a starting dividend of 1.5%.
Finally, this graph shows the initial dividend required for dividend growth to be comparable across stocks with different growth rates (which may help with a valuation if the companies all pay out the same percentage of their earnings as dividends, though this would be a pretty bad way to do a valuation).
Obviously this is all just an exercise in theory, because most folk wouldn’t buy a growth stock with view to living off the dividends in 20 years, because things change. Stocks that were growth stocks could have headwinds 2 years into the future, get bought out, change strategy, run out of space to grow in the market they operate in, etc.
I initially set out to find out if a dividend growth stocks are a better strategy to get a dividend income than stocks with large dividends that don’t grow. I didn’t find what I expected, I expected the growing dividend to outpace the stock with no growth within a decade.
I also ended up proving some other things, which is pretty cool. I think the key takeaways here are:
Stocks that don’t grow won’t make you rich with dividends
Unless you can afford to live off the initial (current) dividend, growth stocks probably won’t provide you with a liveable income within a decade
Dividends are irrelevant if you are not currently investing for an income stream. To rephrase that, dividends should not influence your investing decision unless you’re investing to get an income from dividends
Change is inevitable – giving rise to risk to your dividend income if you experience a black swan event.
All this makes me wonder if the best income stream you can get from stocks is by only buying growth stocks and selling a portion of your portfolio each year.
Addendum: There is a big assumption in the above logic, which assumes that the growth companies are paying out the same earnings as the non growth company and not investing retained earnings. Obviously this is just theoretical because most growing companies retain most of their earnings and only pay a small dividend (if any).
In the event of a growth company keeping most of it’s earnings, then transitioning to pay out more, this would multiply the dividend many times, making the above graphs irrelevant.
That said I still believe that my conclusions remain relevant. I’d love to hear your opinions in the comments, below.