A colleague of mine mentioned the other day that the unusual situation in my city of having no snow on the ground this late in the year makes sense. His explanation was that during a typical year, having even a thin layer of snow on the ground by November reflects a large amount of solar radiation. The effect of this is cooler air temperatures, with almost none of the surface area of the city managing to absorb much heat. When the ground and rooftops absorb a lot of heat, as they would with no snow cover, the heat gets emitted back into the immediate surroundings through convection. The lack of flurries this year has caused that effect to compound well into November as the minor snowfall has quickly melted, keeping the ground in a state that absorbs as much heat as possible and drawing out the above-average temperatures.
This interesting phenomenon perfectly shows the effect that compounding can have. When it comes to stocks, compounding (or, compound interest, as you may have heard) can have some very appealing effects, as well. The first thing to note is that compounding only works with securities that pay dividends or other distributions. Real estate investment trusts (REITs), for example, pay distributions that can be comprised of taxable income, capital gains, foreign non-business income and "other." But regardless of what you call it, getting a cash amount every month, quarter or year could have the benefit of compounding.
Typically, when you hold one of these securities, the distribution goes into the same account that you hold the security in as cash. It will sit there until you decide to take it out or purchase something with it. If you plan on holding a security for a fair bit of time, it may have a dividend reinvestment plan (or DRIP) that you can enroll in by filling out a form and submitting it to your financial institution. DRIPs allow those distributions to automatically purchase (sometimes slightly discounted) shares of the security. So, if you own 100 shares of company ABC (trading at $100/share) that pays $1 per share every quarter, you could instead receive 1 share of ABC each quarter. Note that DRIPs typically allow you to hold fractional shares as dividends won't divide that nicely for the most part. In no other case can you hold fractional shares.
Making use of a DRIP isn't the only way to achieve compounding, it simply is the most direct and automatic way. If you take the cash distributions and use it to make your next stock purchase, that is an indirect way of compounding. You may have only been been able to buy 100 shares of company XYZ, but thanks to your dividends from other stocks you already own, you can buy 102 shares, for example.
So, what does compounding look like in action? Let's use Telus Corporation (TSE:T) as an example, which is one of my stock picks. Here's what the share price of Telus Corporation has done for the last 11 years:
Shares on November 28, 2005 were trading at $21.90 and currently trade at $42.44. If you had bought $10,000 worth of shares back in 2005, your shares today would be worth $19,379 and you would have been paid about $5,767 in dividends during that time, for a total present value of $25,146. Not bad. Let's see what would have happened if you had enrolled in a DRIP for Telus when you first purchased your shares:
As you can see from the above chart, having all the dividends paid in Telus shares over an 11-year period nets you about $28,000, over 10% more than simply taking the cash distributions and leaving them. Note that most stock chart websites typically don't show growth of $10,000 and simply track share price and individual dividend payments. I like using Morningstar as it is the only site I have seen so far that includes the full, compounding benefit of owning a stock for a long period of time.
This "magic of compounding" is something that long-term investors can and should take full advantage of, as the effect of compounding only grows over time. Think of it as dividends on your dividends on your dividends. Whether you choose to enroll in formal DRIPs for your favorite dividend-paying stocks or continually contribute to your investment accounts and use any distributions to pick up a couple more shares of your newest purchase, you'll probably get a warm feeling down the road as you see the extra effect it has.