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I want to build passive income. Reinvesting dividends might help

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One of my main investing goals is to build passive income. It can be a great way to boost a salary, and to provide some extra spending money. But if I can grow my passive income over time, then I’ll be a lot better off in retirement too.

I think dividend stocks are a great way to start building passive income. But what about reinvesting the dividends? It might sound counterintuitive to reinvest the income from dividends at first. However, it could be the best option when first starting out. Here’s why I reinvest all of my dividends today.

Some assumptions

I designed two portfolios to decide whether I should reinvest my dividends.

I assumed an annual 10% growth rate in stock prices. I set the dividend yield at 5%, and assumed the dividend would grow 5% each year. I also chose an initial portfolio value of £10,000 that would be invested in an ISA, so no tax was payable on the capital gains or dividends. My brokerage account also allows me to reinvest dividends without a dealing cost.

In portfolio one, I kept the dividends as cash. In portfolio two, I reinvested all of the dividends and bought more shares instead.

Let’s take a look at the difference between the portfolios after 20 years.

Portfolio one

The final portfolio value after 20 years was £83,800, which is an impressive 738% return. Most importantly, the passive income I would have earned from dividends over the 20 years totaled £16,500. In the last year, the dividend received was £1,263, which is high considering the initial investment was only £10,000.

This shows the power of long-term investing and generating passive income over time.

Portfolio two

This time, instead of taking the dividends I earned as income, I reinvested them back into the portfolio. I can set my brokerage account up to buy more shares in the company that’s paying me a dividend. This means I’d have more shares in the following year, and then a bigger dividend income.

The final portfolio value is much bigger at £121,000, which is a return of 1,110% due to reinvesting my dividends.

The difference here, though, is that I wouldn’t have received £16,500 in passive income over the 20 years as it was all reinvested back into buying more shares.

But what about if I stopped reinvesting the dividends in year 21, and took the dividends from that point on as passive income?

For the first portfolio, my dividend income in year 21 would be £1,327. That’s still a respectable passive income.

For the second portfolio though, because of the additional shares I bought over the 20 years, the income would be £2,433. This is nearly double the passive income I would achieve in the first portfolio.

Risks to consider

The purpose here was to demonstrate why I reinvest my dividends. However, the assumptions were an ideal situation. Stock markets do generally rise over time, and companies are known to pay dividend yields of 5% or more. But this is never guaranteed. Stock markets can crash, and it makes long-term investing difficult when they do. Dividends are never guaranteed either, so this is something else to consider.

But taking it all into account, if I’m able to stick to my plan of dividend reinvestment, then I may have an even bigger passive income stream in retirement.

The post I want to build passive income. Reinvesting dividends might help appeared first on The Motley Fool UK.

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Views expressed in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.