The Latte Effect on the Filthy Rich Animal
Can drinking lattes prevent you from becoming rich?
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Dividends
One way to think about your profitability on an investment is to compare the original purchase price to the current price of that investment. For example, if you bought a stock at $100 last year and it’s at $150 today, you’ve made $50 or 50%.
But that’s only part of the story. When you buy a stock, you become an owner in the company. And that comes with important benefits. For one thing, you may get to vote on corporate issues, like whether to pay Elon Musk $1 trillion. More importantly, you may be entitled to receive something called a dividend.
Lots of companies pay out a portion of their earnings to shareholders as dividends. Mutual funds do the same, paying out the dividends they receive from their holdings as distributions. Whatever they're called, these are cash flows that you receive for being an owner of the stock or fund. And they’re an important part of how you grow your wealth.
How did Earny become a Filthy Rich Animal?
Don’t tell Earny, but that crazy little squirrel is smarter than I am. You see, we’re both about the same age and have been investing for about the same number of years. But Earny reinvested his dividends, while I spent mine on things like lattes and avocado toast. (No regrets! YOLO!)
I won’t go into actual numbers, because it’s embarrassing that a financial professional would be beaten by a woodland creature. But that woodland creature is Earny and he literally is the Filthy Rich Animal. So, I shouldn’t be too upset.
Instead of actual numbers, let’s assume that Earny and I each made $100 mowing lawns in 1995, 30 years ago and invested that money in the Vanguard S&P 500 Index Trust. This isn’t a recommendation for that fund. Rather, it was one of the first index funds and was an easy way to buy the S&P 500 back then.
While I was busy eating my avocado toast and sipping latte’s, Earny’s money was growing more quickly than mine. Remember, he was reinvesting his dividends. So, he earned around 2% more every year than I did. That means that in one year, if I gained $8, Earny gained $10. Earny made about $2 more than I did.
Specifically, the S&P 500 Index returned 8.64% on average each year excluding distributions during this time. Earny, earned 10.73% per year over the same period by reinvesting his distributions.
So, based on that original $100 investment, and assuming I spent my distributions every year on lattes and avocado toast, how much more money does Earny have than I do?
1. Earny’s investment is worth about 20% more than mine
2. Earny’s investment is worth about 40% more than mine
3. Earny’s investment is worth about 60% more than mine
4. Earny’s investment is worth about 80% more than mine
Answer: How much more money does Earny have?
An extra 2% per year doesn’t seem like much. On a $100 starting point, it’s just $2 more than the $8 I would earn! That’s not even enough to buy a latte. The thing is, it adds up. Every year, Earny’s frugality gives him a big bump over my return.
In the end, Earny is 80% richer than I am!
80%!
Earny’s $100 grew by about 10.73% per year and is now worth $2130. I purchased the same fund that he did but I spent my distributions. Therefore, my gains fall to 8.64% annually and my account is worth just $1,200. Still a nice return, but much less than Earny’s.
To sum it up, when a stock pays you a dividend (or a fund pays a distribution), it’s your money and you can do with it whatever you want. You can eat avocado toast and you can visit your favorite coffee shop. However, you can also reinvest it back into that original investment. You can even reinvest dividends from one security into a completely different security!
The point is, don’t overlook this cash flow as a source of increasing your portfolio’s return. This small amount of cash can lead to enormous improvement in your wealth over 5, 10, or 20 years.
One big caveat! In this example, I’m ignoring taxes. Dividends and distributions are taxable income, but, unless Earny and I had invested in an IRA or 401(k), we’d have had to pay similar amounts in taxes. Earny would still be richer than I would be, but the numbers would be a little different.
