With patience you can use dividend snowball investing to compound your way to earning enough income from dividend stocks to pay your bills and become financially independent.
When you were a kid, did you try building a snowman (or woman!) by rolling snowballs on the ground? As you rolled the snowball, it became little larger with the snow it picked up. Consider how dividend snowball investing works in the same way through dividend reinvestment to continue to grow your dividend paying shares.
First, let’s consider how Dividend Snowball Investing works
The original concept for dividend snowball investing is based on David Ramsey’s debt snowball method. With the debt snowball, you pay off the smallest balances first and then use that money to pay off your next debt balances. Your ability to pay off your debt by clearing away the smallest balances so you can consolidate your debt paying money.
Dividend snowball investing focuses on the compounding effect of reinvesting dividends back into the same investment. When you reinvest your dividend payment your investment grows slightly larger. In the future you’ll receive a slightly larger dividend payment. With enough time the growth effect is amazing, assuming you invested in solid companies of course.
If you do not reinvest the dividends or in some way increase the shares that you have in a particular company, your dividend increases will only come from annual dividend payout increases declared by the company. For example Coca-Cola (KO) annually increases it’s dividend.
If you have 20 shares of KO and take the cash instead of reinvesting, each year you will receive a slightly larger dividend payout. If you reinvest that dividend payout into partial shares of KO, each payout grows slightly faster because there are additional shares plus the larger per share payout.
The only other way to receive additional shares if you don’t reinvest or purchase new shares, would be a stock split (though the dividend is also split) or through a merger that results in new shares. Both would give you a boost in the long term ownership and dividend payouts, but neither are usually frequent events.
Deciding to reinvest your dividends or not
Dividend snowball investing requires additional shares to be created (or purchased), in addition to annual payout increases for the method to be most successful.
Automated Reinvestment vs manually purchasing shares
For anyone that follows dividend investing blogs, there are strong opinions on if you should automatically reinvest or take the dividend cash. Some people will argue to watch the price of the stock to determine if it’s the right value. Could you find a better investment elsewhere? This may be true, but don’t forget that you’ll likely need to pay a trade commission if you use the money to make purchase.
Run the math on how many shares you may receive
One of the first mistakes I made when I started dividend investing was that I didn’t do the math to determine how many partial shares I would receive based on the current dividend and the number of shares I was about to purchase.
Reinvesting dividends into partial shares is great until you realize that you’re only receiving a .001 share of stock. That’s going to take YEARS to reach 1 full share.
And tip, if you need to move your investments between investing houses, those partial shares will be liquidated, because they can only transfer WHOLE shares. YEAY, paperwork for the next tax year and you’re back where you started.
My 2-cents, for each company you are thinking about investing in, reverse engine how many shares you need to reach either one quarter of a share per year at a minimum. Of course this isn’t a guaranty given price fluctuations, but it’s enough of a guideline to help you actually make progress on growing your holdings. Depending on the dividend yield of the stock, you may receive a bit of sticker shock on how much you need to invest.
Don’t take this as a hard rule for investing and potentially invest what you can at the time and purchase more shares in the future. I’ve done that too.
Make sure you purchase a stock with a history of paying dividends
This probably goes without saying, but to improve your chances of a successful buy-and-hold growth strategy, you need to purchase shares from a strong company with a long history of paying and increasing dividends. Companies such as the dividend kings that have at least 50 years of paying dividends are a “safer” bet. Nothing is guarantied, especially in the stock market.
Don’t forget about income taxes
One of the things I didn’t understand when I started investing, when I needed to pay taxes on dividends. You need to pay income taxes on dividend income even if you reinvest it. Make sure you check with your favorite tax professional (or a nifty tax prepration software) for more information to understand what taxes you’ll owe. And don’t worry, yes I paid all of my taxes when they were due!
You also need to pay attention to the type of companies you invest in. Some companies will result in qualified dividends (in general most blue chip stocks), which you’ll pay a lower tax rate compared to an investment that pays ordinary dividends (potentially a REIT – Real Estate Investment Trust). That should not necessarily stop you from buying one type of stock over another. You want to make sure you make an informed choice.
For example, when I’m deciding which company I want to buy shares in, in addition to looking at the company’s health, I also calculate the current dividend yield after taxes (roughly). I want make sure I’m being efficient with my investment purchases.
Over to you. What do you think about the Dividend Snowball Investing?
Have you tried dividend snowball investing as part of your wealth building strategy? What’s worked well for you? Do you have additional tips to share?