Remember when you were a kid and rolled a snowball on the ground to build a snowman (or woman!)? With each roll of the snowball it picked up a little more snow to become larger and larger. Dividend snowball investing works in the same way with each dividend reinvestment helping your future dividend payments grow and grow.
If you’re building a dividend portfolio for monthly income, this growth strategy will help you progress towards your goal with time and patience.
How dividend snowball investing works
Dividend snowball investing is based on David Ramsey’s debt snowball method. In a debt snowball, you tackle your debt by paying off the smallest balances first and then using the money towards your next debt balance. Your speed at paying off as you reduce the number of balances you need to pay because your minimum payments are spread across fewer accounts.
While a little different, dividend snowball investing uses the compounding effect of reinvesting dividends into the same investment to increase your future dividend payments. With each reinvestment your shares grow slightly larger. With slightly more shares, your next dividend payment is sightly larger. With enough time invested in solid companies, the growth effect is amazing.
If you do not reinvest the dividends or in another way increase your shares in the investment, your payment growth will only come from the companies increasing the dividend rate per share. In most cases the companies will increase dividend rates annually .
If you have 20 shares of The Coca-Cola Company (KO) and take the cash instead of reinvesting the dividend, 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 add shares to your holding, besides buying them, would be a stock split or potentially a merger which results in new shares. With a stock split the dividend is also split. In the long term you’ll have a boost ownership and dividend payouts, but neither are usually happen frequently.
Deciding to reinvest your dividends or not in your dividend snowball
For the dividend snowball to grow faster, additional shares need to be created (or purchased) in addition to annual payout increases.
Using automated reinvestment vs manually purchasing shares
In the DIY investing community there are strong opinions on automatic reinvestment vs taking the dividend in cash. Some people prefer to watch the stock price to find the best value. Can 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 make manual purchase versus having it automatically reinvested.
Make sure you calculate how many shares you may receive
One of the first mistakes I made when I started dividend investing was that I didn’t check the math to understand how many partial shares I would likely receive based on the current dividend from the shares I was about to purchase.
Reinvesting dividends for partial shares is great until you realize you’re only receiving a .001 share of stock. It will take DECADES to reach 1 full share.
And if you need to move your investments between brokerage companies, those partial shares will be sold because they only transfer whole shares. Not only are you back to where you started with that holding, you have additional paperwork to deal with for the next tax year.
My 2-cents, for each company you are thinking about investing in, calculate how many shares you need to reach either one quarter of a share per year at a minimum. With price fluctuations it might not turn out 100% as estimated, but it’s close enough to help you actually make real 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. Start where you can and potentially buy more shares in the future when you have more money, and the value looks good. I’ve done that myself.
Make sure you purchase a stock with a history of paying dividends
To improve your chances of a successful buy-and-hold dividend snowball strategy, you need to purchase shares from strong companies with a long history of paying and increasing dividends.
While past performance isn’t a 100% guaranty of future returns, companies such as the dividend kings that have at least 50 years of paying dividends are a “safer” bet.
You do the best that you can with the information you have at the time, especially in the stock market.
And, don’t forget about income taxes
Another thing I didn’t understand when I started investing was I needed to pay taxes on dividends. You need to pay income taxes on dividend income, including the reinvested income you received in non-retirement accounts.
Check with your favorite tax professional (or tax prepration software) for more information to understand what taxes you’ll owe. Avoid the same surprise I had at tax time.
You should also pay attention to the type of companies you invest in. The dividends from some companies will result in qualified dividends which is taxed at a lower rate than ordinary dividends. Qualified dividends are usually from blue chip stocks and have rules around how long you hold the shares. Ordinary dividends usually come from Real Estate Investment Trust (REIT) companies or shares you don’t hold long enough.
Don’t let this stop you from buying one type of stock over another. You want to make sure you make informed purchase decisions.
When I am about to buy new shares, I look at the company’s health and estimate the current dividend yield after taxes. I want make sure I’m being efficient with my investment purchases. I try to make sure I’m doing what makes the most sense in the moment,
Wrapping up. What do you think about the dividend snowball investing?
Growing a dividend snowball with enough patience can be used to pay our bills and replace your regular income in the future. Have you tried dividend snowball investing as part of your wealth building strategy? Or have you decided this is not the right approach for you?
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