Have you checked CNN lately? The world is an unpredictable place.
The uncertainty surrounding the world is why saving is so important. A buffer against the randomness of the world provides peace of mind. The more of a buffer you have, the more turbulence in life you are prepared for.
There are countless emergencies and planned events in life that we must save for. A brief and far-from-exhaustive list is below:
- Medical bills
- House repairs
- Family education
Inflation Is The Enemy of Your Savings Account
Inflation is the increase in in prices and fall in purchasing power of money. When inflation occurs, the value of your savings decreases.
Inflation is a hidden wealth tax. If your money is not growing, its shrinking. If we lived in a deflationary environment, money would be worth more over time. There’d be less incentive to generate a return on your investment.
That, however, is not the world we live in.
The Federal Reserve has a target inflation rate of 2% a year. Every year your money loses 2% of its value (if the Federal Reserve hits its target). The average historical inflation rate in the United States is 2.25%.
Approximately every 36 years (at 2% inflation), your savings lose half their value if they are not earnings a return. Obviously, this is not an ideal situation.
Make Your Money Work For You to Fight Inflation
The highest national savings accounts are currently paying interest of 1.1% a year. With inflation expectations of around 2% on average, this will result in declining purchasing power.
Fighting inflation is just one reason to make your money work for you. Even with no inflation, it is more beneficial to have your savings account grow in value rather than stay stagnant.
Over a long period of time, your savings have the potential to generate more income than you can in your normal life if invested wisely.
The mathematics behind compounding your savings are very compelling. They are most easily understood using something called ‘The Rule of 72’.
The Power of The Rule of 72
The Rule of 72 is a quick-and-dirty way to calculate how long your savings will take to double at a certain rate of return.
To calculate the time it will take your savings to double, simply dividend 72 by your expected rate of returns. A few examples are below:
- With a 3% return your savings will double in approximately 24.0 years
- With a 5% return your savings will double in approximately 14.4 years
- With a 7% return your savings will double in approximately 10.3 years
- With a 10% return your savings will double in approximately 7.2 years
The higher your return, the quicker your savings will double. When calculating the future value of your savings, remember to subtract inflation from your expected rate of return. Expected return less inflation is the expected real rate of return – how quickly the value of your savings is growing.
The numbers above assume you are not making additions to your savings account. Adding money only amplifies the effect of compounding.
Another important aspect of the Rule of 72 is the power of compounding. Savings invested at a 10% real rate of return will double in value in about 7 years. After ~21 years, you will have eight times the value of your initial investment… That’s because 3 ‘doubles’ equals eight. After another ~7 years, you’d have 16 times the value of your initial investment.
“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
– Attributed to Albert Einstein (origin of quote is disputed)
The immutable formula below is responsible for many great investing fortunes:
Compound returns plus time equals abundance
Why Dividend Growth Stocks Are Perfect Savings Vehicles
There is a particular investment vehicle that embodies the ideas of compounding.
The investment I’m talking about is high quality dividend growth stocks. The best dividend growth stocks raise their dividend payments every year. The dividends the company pays out to its investors can be used to repurchase more of the company, which continues to pay more dividends each and every year. Dividend growth stocks are a fantastic investment for those looking for long-term compounding vehicles that require minimum maintenance and time.
I like to think of a dividend growth portfolio as a snowball rolling down a hill. Over time, the snowball picks up more snow and eventually becomes massive. The Calvin & Hobbes comic strip below shows this concept:
‘Snowball Investing’ works in the real world. Click here to see 5 examples of real-life ‘snowball’ dividend growth stocks that have greatly compounded shareholder wealth over the last 25 years.
Where to Find Dividend Snowball Stocks
The quickest and easiest way to identify high quality dividend snowball stocks is to select stocks from the Dividend Aristocrats Index.
The Dividend Aristocrats Index is comprised of 52 businesses that have increased their dividend payments for 25 or more consecutive years in a row. The index is filled with well-known businesses like Coca-Cola (KO), Clorox (CLX), Wal-Mart (WMT), Procter & Gamble (PG), and PepsiCo (PEP).
You can see all 52 Dividend Aristocrats at this link. It may not surprise you that the Dividend Aristocrats Index has outperformed the S&P 500 by over 2 percentage points a year on average over the last decade.
At this level of outperformance, the Rule of 72 shows that an investment in the Dividend Aristocrats would be worth double the S&P 500 after around 36 years. The image below shows the performance of the Dividend Aristocrats Index versus the S&P 500 over the last decade.
It is my hope that this article imparted two ideas for consideration:
- Having a savings buffer is critical in an uncertain world
- Dividend growth stocks will compound the value of your savings
When considering where to invest your savings, I firmly believe that investing in high quality dividend growth stocks is the most appropriate investment vehicle for individual investors. That’s why I created The 8 Rules of Dividend Investing in particular and Sure Dividend in general; to simplify the process of investing in ‘dividend snowball’ stocks.