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TFSA Wealth: How to Harness the Power of Compounding

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Written by Andrew Walker at The Motley Fool Canada

Canadian savers are using their Tax-Free Savings Account (TFSA) to build portfolios of investments as part of their overall retirement-planning program. One popular strategy for creating long-term wealth involves reinvesting interest and dividends to grow savings.

Power of compounding

When a person rolls a snowball to make a snowman, it is a good lesson on how the power of compounding works. Each rotation picks up more snow, making the snowball larger, enabling it to pick up even more snow on the next roll.

The same thing can happen to investments, although the impact tends to take longer. In the case of fixed-income investments like Guaranteed Investment Certificates (GICs), investors often have a choice of compounding the interest over the term of the investment. For example, $1,000 invested in a five-year GIC that pays 5% interest annually provides a total gain of $250 if the interest is paid out each year. When the interest is compounded, the total gain at the end of the five years is about $276.28.

Another strategy involves owning top dividend-growth stocks and using the distributions to buy new shares. Many companies offer investors a discount of up to 5% on the share price when distributions are reinvested in new stock.

Owning stocks come with risks. Share prices can fall below the purchase price, and dividends can get cut if the company runs into financial problems. Top dividend-growth stocks, however, tend to bounce back from market corrections. When the share price falls, the dividends can actually buy more stock. Over time, great dividend-growth stocks tend to deliver attractive capital gains on top of the steadily rising payouts.

GIC rates are now above 5%, and some top TSX dividend stocks are currently offering yields of 6% or 7%.

BCE

BCE (TSX:BCE) is a good example. Canada’s largest communications firm has a current market capitalization of close to $52.5 billion. This gives it the financial clout to make the investments needed to drive long-term growth.

The company’s wireless and wireline network infrastructure delivers mobile, internet, TV, and security services to commercial and residential customers across the country. BCE also has a media division that owns a television network, specialty channels, radio stations, digital platforms, and interests in sports teams.

The media group is struggling with a difficult advertising market, and soaring interest rates are driving up BCE’s borrowing costs. This is largely why the stock is down over the past year, currently trading near $57.50 compared to more than $70 at the peak in 2022.

At this point, the drop looks overdone. BCE remains very profitable and expects total revenue and free cash flow to actually grow in 2023 compared to last year. Investors who buy BCE stock at the current level can get a 6.7% dividend yield. The board raised the dividend by at least 5% annually for the past 15 years.

A $10,000 investment in BCE 10 years ago would be worth about $22,000 right now with the dividends reinvested.

The bottom line on building TFSA wealth

It takes patience and discipline to ride out market dips, but investors can build significant long-term savings from relatively modest initial investments when they harness the power of compounding in their portfolios. In the current market conditions, it is possible to build a diversified portfolio of GICs and top dividend stocks to get attractive yields to build TFSA wealth.

The post TFSA Wealth: How to Harness the Power of Compounding appeared first on The Motley Fool Canada.

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The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. Fool contributor Andrew Walker owns shares of BCE.

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