I’m aiming for millionaire status via income stocks and the miracle of compounding!

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I’m using income stocks to generate wealth in the long run. While income stocks provide me with regular, but not guaranteed, payments, I rarely take this money to fund my life. Instead, I reinvest my dividend payments.

This is a process called compound returns, or compound interest.

Essentially, people who already have money find it easier to get more money just by leaving their investments to grow. It’s very much like a snowball effect. The longer I leave it, the larger the pot becomes.

How it works

I’m fortunate in that I don’t need the dividends I receive from my investments right now. So I reinvest them every year. It might not sound like a winning investment strategy, but it really is.

For example, if I invested £10,000 in a company with a 5% yield, at the end of the year, I could expect to have £10,500, assuming the share price of the stock in question remained constant.

That sounds ok, but it’s not groundbreaking. The impressive bit comes when you reinvest that dividend year-on-year.

So assuming the dividend remains at 5% and I keep reinvesting my chunk of its payout, I could expect my £10,000 to be worth £27,000 in 20 years. That’s the power of compounding. 

And if I were to reinvest my dividend for 30 years, I could expect more than £47,000. That’s a huge return on my original investment.

Supercharging my compounding strategy

So what would happen if I were to invest a little extra cash every month for 20 years? Well, it will have a huge impact, but obviously it will cost me money in the short term.

If I invested £10,000 in a stock paying a 5% yield, and then invested £200 every month, after 20 years I’d have a whopping £109,000. And if I did it over 30 years, I’d have £211,000.

For me, this is certainly the most effective way for me to generate wealth in the long run without the risks associated with investing in growth stocks.

If we assume that I have £50,000, I invest £10,000 in five firms, then add £200 to each pot every month, after 30 years, I’d have over a £1,000,000 in stocks and shares.

Naturally, there’s no guarantee that my strategy will work and I could lose money, but I contend there’s less risk here than investing in growth stocks.

It’s also worth noting that share prices should move upwards over the long run. If they don’t, it means I haven’t picked my stocks very well.

Picking my stocks

It’s vital that I make sensible choices. I want to choose companies that are still going to be around in 30 years. I’m not going to be picking companies that I don’t think have the required longevity. So that’s a ‘no’ to tobacco and fast-food stocks then.

Instead, I want steady income stocks that aren’t likely to fail. I’d pick big banks like Lloyds and NatWest. They’ve been around for years and I don’t see them leaving the market any time soon.

I’d also look at insurers such as Aviva or financial services firms such as Legal & General. All these stocks are offering strong dividend yields right now.

The post I’m aiming for millionaire status via income stocks and the miracle of compounding! appeared first on The Motley Fool UK.

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James Fox owns shares in Lloyds Bank, Legal & General, NatWest and Aviva. The Motley Fool UK has recommended Lloyds Banking Group. Views expressed on the companies mentioned 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.