For most investors who go down the passive income route, it is no more than a way to add a little extra cash every year. This is because the average yield of the FTSE 100 is around 3.4%. And for investors working with smaller sums of cash, this amounts to little compared to the lure of investing in trending stocks that could skyrocket in a year.
We are all aware of the power of compounding returns. What if I combine the safety of passive income and the power of compounding returns to boost long-term earnings? Can this strategy help me turn my passive income into a retirement-worthy sum?
DRIP investing to boost passive income
Short for ‘dividend reinvestment plan’, DRIP investing is a less-explored style of using passive income, which could grow returns over the long-term by two or even three times (3x). The idea is simple: every time I receive a dividend payout from my investment, I reinvest it back, repurchasing shares in the same company.
This strategy allows me to increase the number of shares I hold in the company. And this, in turn, boosts my payouts every year, which allows me to repurchase a larger chunk of shares. And as I follow the Foolish investment philosophy of investing for the long term, this could vastly boost my returns if I pick the right dividend stocks.
DRIP vs normal dividend investing
Allow me to demonstrate the possible returns with the magic of mathematics. I have chosen dividend aristocrat Legal & General (LSE:LGEN), which has a current yield of 7.4% and has historically generated strong capital every year (with plans of boosting yield year on year).
I am willing to invest a £10,000 lump sum investment in the company with plans of holding it for 30 years. This would get me 4,098 shares at the current share price of 244p. I am placing the average yield of Legal & General shares at 5% (accounting for fluctuations) paid annually, with a 3% increase in yield every year and 0% share price growth.
Without DRIP investing: after 30 years
Final investment value: £10,000 (assuming 0% share price growth)
Final dividend income: £23,785.61
Total investment returns: £33,785.6
With DRIP investing: after 30 years
Dividend contribution: £88,146.52
Total investment returns: £98,145.64
It is clear that, over time, this passive income strategy could yield nearly 3x more than just holding dividends. And at the end of 30 years, I would own 35,983 shares in the company.
Although I assumed a share price growth of 0%, it will fluctuate. If there is a fall in share price, the yield could go up in relation, boosting my returns. If there is share price growth, I could turn my £10,000 to £100,000 with this strategy.
Risks to consider
A passive-income strategy comes with risks, too. Any company could cut dividends if revenue is affected. And for Legal & General, economic turbulence could affect income as it operates in the finance sector. A long history of dividend growth does not guarantee future returns. And for this strategy to succeed, a steady payout is absolutely crucial.
It is clear that picking a winning passive income share is the first step. But I think by sticking to blue-chip dividend shares and being diligent, I could vastly boost the earning capacity of my portfolio using the DRIP method.