With every investment that an investor makes, he is, in essence, deploying his capital to get a decent return. This assumes that the investor would have a stash of capital to deploy whenever he encounters a great investment idea, backed by a robust investment thesis.
During our productive working years, capital generation usually isn’t a problem as we are actively engaged in employment, and are also easily hireable. However, when we are approaching our golden years, we want to ensure that we can rely on a steady income stream so that we can retire happily and not have to slog for money. This concept is known as “financial independence”, where a person’s passive income stream from investments is able to cover his living expenses and provide him with an acceptable standard of living.
Some people manage to achieve financial independence faster than others, and this is through consistent investing and compounding. In particular, the process of compounding one’s dividends can help to accelerate the path towards financial independence.
Dividends as a form of passive income
Dividends are paid out of companies’ profits and represent a return on an investor’s investment in the company. They represent a form of passive income as the investor does not actively need to “work” or do anything to qualify for the dividend. He simply needs to own shares in the company to be eligible to receive the dividend.
The process of reinvesting dividends
As an investor deploys more and more money into investments, these investments will throw off higher levels of dividends over time. An investor can derive capital from active income (i.e. as a salaried employee or self-employed individual), obtain capital from the dividends which he receives, or a combination of both. The process of investing his dividends to buy more shares of dividend-paying companies is known as compounding. It is a very powerful force as one is using dividends to generate even more dividends.
The (winding) road to financial independence
The path towards financial freedom is not always smooth, though. Some companies may reduce or eliminate their dividends along the way as their businesses face competitive and cost pressures. Investors need to ensure they consistently try to compound their dividends in strong, growing companies in order to reap the fruits of their efforts. Hitting upon a dividend champion would be an ideal situation for a person seeking financial independence, as the growth in dividends would accelerate the investor’s journey.
As dividends continue to be reinvested and compounded, there will come a time when the dividend flow from investments exceeds the investor’s daily living expenses. This would be the point at which financial independence is achieved, and a lot of time, patience and tenacity are needed to reach this end goal.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.