The first five steps are pretty self-explanatory. But Step #6 is a little unusual. Let’s go through an example to illustrate Step 6.
John loves being outdoors, and enjoys water sports in particular. He has had his eye on a jet ski for a couple of years, but he always felt like it was an extravagance that he really couldn’t afford.
But on the morning of his 35th birthday, John decides to give himself a nice present. He has managed to save $5,000 in a special “fun” savings account over the last couple of years, and so he goes out and finds a great deal on a new jet ski for $4,800, and buys it for cash.
John loves his new jet ski, and has a blast over the next couple of years taking it out every few months.
While his purchase has paid off amazingly well in terms of fun and entertainment, let’s see what this purchase has done to his finances and wealth-building plans.
At the end of two years, John’s jet ski is only worth $2,400 due to wear and tear. The jet ski has cost John $2,400 over 24 months, which is $100 a month.
He has been very happy with his purchase and has had a lot of fun, but all his friends are all moving on to skiing.
John sells the jet ski for $2,400 and puts the money back in his “fun” savings account.
All in all, John took the jet ski out about 10 times over the 2 years he owned it.
At the end of a fun day of jet skiing around the lake, John is sitting with his friend Tom. They are kicking back drinking beers and enjoying the sunset. Their conversation soon turns to money.
John noticed that Tom would just rent a jet ski each time they went out, and he would share the $200 cost by going in on it with another friend of theirs.
Tom tells John that he also saved $4,800 in his “fun” savings account, but he decided to take a different route with his money. Tom took his $4,800 and purchased a dividend-paying stock that had a 6.3% dividend yield, paid quarterly. The stock was $8.00 a share when he bought it, so he was able to purchase 600 shares. He receives $75 each quarter, or $25 a month, from the dividend. At the end of two years, Tom has received $600 in dividend payments.
Tom had the same amount of fun as John, but his financial picture is much different. In addition to the fun jet skiing memories, Tom now owns 600 shares of a stock that pays him $25 a month.
Tom figures that he spent $1,000 on renting the jet ski – he paid half the $200 rental fee each time they went out which was 10 times or 10 rentals.
He received $600 in dividends over the last 2 years, so all the jet skiing fun over the last 2 years only cost him $400.
As their jet ski period ends and they move on to skiing, Tom sells his 600 shares of stock at the current price of $9.50, which is $5,700. After subtracting the $400 spent on renting the jet ski, Tom puts $5,300 in his “fun” savings account, which is $500 more than when he started!
John is left with $2,400 from his initial $4,800. He is $2,400 poorer.
Tom has $5,300. He is $500 richer.
Let’s clarify what Tom did differently than John:
1) Tom decided not to buy the jet ski, which he saw as a liability, one that would depreciate (lose value) over time, and involve costs for storage, transportation, gasoline, maintenance, cleaning, etc.
2) Instead, Tom decides to purchase an asset that would help him pay for renting a jet ski.
3) Tom did not rely on hoping his investment in the stock would go up. He carefully chose a stock that already had a strong record of paying dividends, and would likely continue to do so for the next couple of years.
4) Even if the stock price stayed at $8.00 for the 2 years and never went up, Tom could have sold his shares for $4,800. And he still would have made $600 in dividends over the 2 years.
After subtracting the $400 he spent for jet ski rentals, he would still have been able to put $4,400 in his “fun” account, vs. John’s $2,400.
5) Even if the stock declined sharply, Tom would still have come out ahead of John. The stock would have to fall to under $4.00 for Tom to end up with $2,400, the same as John. But Tom, being a careful investor, would have sold his shares long before it got to $4.00 (via a stop-loss sell order placed no more that 8% below his purchase price).
Tom wanted to use his dividends to pay for the jet ski rental. There was nothing wrong with that, but he could have taken a more lucrative path with this investment, one that used compounding. He could have taken the $600 dividend income he received and purchased additional shares.
By the end of the two years he would have had approximately 675 shares, not 600, and his monthly dividend income would also have risen due to the increased number of shares. Compounding combined with the reinvestment of dividends is a surefire way to riches.
Jodie
Pretty! This was an incredibly wonderful article.
Thanks for providing this information.
John
This is a great article. I’ve seen many explaining dividend stocks, compounding and not putting your eggs all in one basket. I think what most first time investors or people on the fence on whether to invest are concerned with is, who do we go to, who do you trust with your money? Instead of a stock broker who takes a percentage what are the trustworthy entities and websites to use that can maybe coach you along your first and future investments investment?
Michael
Hi John,
Always look for a fiduciary when dealing with investing professionals, whether they are wealth managers or stockbrokers. They are required by law to put your needs ahead of their own.