The 2 Secret Income Boosts to Using “YoC” – Daily Reckoning

This post was originally published on this site

On Monday, November 6th, we sent you a Roadmap to investing in companies that boast long histories of steadily rising dividend payments.

And on October 31st, we sent a Roadmap about the power of reinvesting your dividends for bigger and bigger compounding gains.

Today’s Roadmap shows you the intersection of those two topics.

It’s a fundamental concept…

But it has big implications for ANY type of income investment you ever look at from here on out.

It’s called “yield on cost.”

Yield on cost is the amount of income you’re making from an investment based on what you originally paid for it.

For example, if you buy a $100 stock that pays $5 a year in dividends, your annual yield is 5%.

But if the company’s dividends go up to $10 a year down the line, your yield on cost — or your effective yield — is now 10%!

This is true even if the stock has gone up to $200 a share and major financial websites are showing its yield as 5% again.

Why?

Those are indicated yields — next year’s projected income divided by the stock’s current price. It doesn’t consider what you actually paid — $100 — at all.

Very few people keep track of the effective yields on their current holdings.

That might lead them to make bad decisions about how those positions fit in their portfolios..

Worse, most investors almost certainly only focus on indicated yields when they’re considering making new investments.

That’s a big mistake that can grow larger the farther out in time you go.

Let me show you why.

Say my buddy Mortimer has $10,000 to invest.

He’s torn between a dividend stock and a 10-year Treasury bond.

Since they’re both yielding 2.3% right now, Mortimer picks the bond. After all, it carries no risk of loss as long as he holds it until maturity. And he values safe income more than the chance for price appreciation.

Well, here’s the thing …

The bond, by definition, is a fixed-income investment. That means its yield will also never change over the 10-year holding period. Every year, Mortimer’s $10,000 will pay him $230 in income.

In contrast, the dividend stock is from one of those firms that consistently hikes its payments every single year — about 5% on average.

So although Mortimer would earn the same $230 in his first year of ownership, his future income would go up in every subsequent year.

By year 10, he’d be getting a 2.82% yield … half a percentage point higher than the Treasury bond’s yield.

This isn’t the most exciting illustration but it demonstrates why companies that consistently increase their dividends are often much better long-term investments than any type of bond.

What’s more, if you reinvest those increasing dividend streams you actually get a whole second layer of compounding …

Compound effect #1 is the simple fact that reinvested dividends are buying more shares which are then producing more dividends.

Compound effect #2 is because the per-share dividend payments themselves are ALSO increasing every year just by themselves.

And from what I’ve seen, the market also tends to reward companies that consistently increase their dividends by bidding up prices over time anyway.

That means you stand a high probability of getting capital gains on top of your growing income!

In fact, this is precisely why some of the very best income stocks always seem to sport the same basic annual yields over time as I alluded to earlier.

It’s not because the dividends are staying the same. It’s because the stock prices are rising in lockstep!

The same basic dynamics are at work in other parts of the investment world, too … including real estate that commands higher and higher rents while also gaining in value.

So no matter what you’re looking to invest in, always make sure you consider every aspect of the income potential — not just in the immediate future but also farther out in time.

To a richer life,

Nilus Mattive
for The Rich Life Roadmap

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