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Compounding Snowballs

A well known Warren Buffett quote is about a snowball.


"Life is like a snowball. The important thing is finding wet snow and a really long hill."


He is saying that to compound, or to increase the size of your "snowball" you need two very important things. One is wet snow, otherwise known as a stock that has a good rate of return and a yield that will with time increase the value of your snowball. That leads me into the second item, a really long hill. What Mr. Buffett is referring to is time, you need time to really see your stock grow. In this post I will be talking about how to know how long it will take your snowball to double in size and the difference between reinvesting your dividends and spending the money.


A simple estimate to figuring out how long it will take for the money you invested in a stock to double is The Rule of 72. Unlike other investing rules you can easily find the amount of time it will take to double in value just by having the rate of return.


Let's say Ginnie wants to invest in Smarticles Inc., she has done all the research and checked all the boxes on the balance sheet and valuation, but she still has one more question, “How long will it take for me to double my money in Smarticles Inc.?” Ginnie pulls out her handy-dandy newspaper and researches to calculate her rate of return.( I will explain how to calculate the estimated rate of return in a stock in an upcoming post.)  She finds that Smarticles has a rate of return of 8%. To find her final estimate Ginnie has to take the number 72 and divide that by the company's rate of return, 8%. That will give her a total of 9 years.


Please note, this rule does not give you the exact answer. For the exact amount of years it will take you to double your money you can find a calculator online.


With my Ginnie example I only went so far in depth as to explain the way to use the rule of 72. We never thought about the difference of using that rule if Ginnie had reinvested her dividends compared to her spending them. What is the difference you might ask? When we later look at data tables you immediately notice a difference. Reinvesting dividends is like putting more money into your stocks, or adding shares, if you think of it that way it will obviously mean a faster increase. Two people may buy the same stock, they might get the same amount of share but what will happen if one reinvests their dividends and the other doesn’t? That is what we are about to look at.



If you look at the picture above you will notice that there are two lines, they have the same dividend growth rate, 7%, and the same current yield of 5%. For some reason we see a very large difference in how the dividend is growing. Why? The blue line is reinvesting dividends and the orange one isn't. Obviously the blue line is growing at a much higher pace than the orange line.


Let's pretend the blue line belongs to Jackie, Jackie is 10 years old and bought $100,000 in Smarticles Inc. stock. Yes I know that is a lot of money for a ten year old to have, but let’s pretend she has been very successful in the lemonade business.  Because Jackie is so young she isn't in a rush to acquire and spend her dividends, actually it would be more profitable for her to keep reinvesting until she needs the money or the stock isn't performing the way she wants it to.


Jill is much older than Jackie and she's retired. Jill bought the same stock as Jackie did, it has the same yield, the same growth rate and she also paid $100,000 for the stock. The difference is that Jill has no other income, she is living off of the dividend that Smarticles is giving her so she can't reinvest it. Neither one of them is doing anything wrong, they are both right. This is why people say to start early on investing, not only will the knowledge help you in the long run but you have more options. Jackie, at 10, will not have to worry about other costs within her life like electric bills or rent so she can afford to reinvest her dividends.




10 Years Later.


Both Jackie and Jill use The Rule of 72 to calculate how long it will take for their money to double. They take their rate of return, 7%, and divide that by 72. That gives them the answer of a little over 10 years. If we refer to the image above you can see that at year ten the blue line, Jackie, has more than doubled her starting $5,000 of dividends. Jill’s money has compounded and grown but there is still more to go if she wants to double her money.


When Jill and Jackie first invested in the stock there was no difference, now that one chose to reinvest dividends and the other didn’t there is a difference of $4,673 of dividends. In year 20 of owning Smarticles Inc. they will have a difference of $24,981. Just by looking at the differences of the two owners you can see how much the stock has compounded and grown. Jackie invested in Smarticles when she was 10, if she continued to hold it for 20 years she would get $43,064 of dividend. And that is the power of compounding and reinvesting dividends.  



Jackie
Total Dividends
Jackie YOI
Jill Total Dividends
Jill YOI
Original investment
$5,000
5%
$5,000
5%
Year 5
$7,868
7.87%
$6,554
6.55%
Year 10
$13,865
13.87%
$9,192
9.19%
Year 15
$24,436
24.44%
$12,893
12.89%
Year 20
$43,064
43.06%
$18,083
18.08%
***YOI stands for Yield on Original Investment.***


As I said in the "disclaimer" The Rule of 72 is not exact. In Jackie's case that's helpful, she's predicting to double her money at year 10 but really has already done that at year 8 and is about $4,000 past doubling her money at year 10. Jill is very close to doubling her money but has not yet reached that point. Not until year 12 does Jill double her money.


The Rule of 72  is a helpful tool. It can help you predict when you will double your money and if you keep reinvesting your dividends. This rule is helpful for planning, once you figure out how long it will take to double your money in a stock you can set boundaries on time. Some people don’t have 20 years to wait for their money to double.


The main take away from the example with Jackie and Jill is: it’s better to reinvest your dividends. You could see the difference between the two investments and in the long run Jackie would have more money. I am in no way saying that Jill is wrong, you shouldn’t spend you dividends unless you have to, and in Jill’s case she did.

Reinvesting dividends is like having the perfect snow for a snowball and finding that ideal long hill.

If you read more on investing please click the title below to a book my father and I wrote about kids and investing. It's called A Very Long Hill: A Daughter and Her Father's Journey For The Long Run.

Comments

  1. Well done, Maya! The power of compounding is one of the most important lessons a young investor can learn!

    “Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it.” -- Albert Einstein

    ReplyDelete

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