‘Past performance is not a predictor of future performance and you may lose some or all of your investment’ is the mantra you hear from all trustworthy investment brokers. So why do we invest in high risk FTSE companies when we can just park our money ‘safely’ with banks earning passive income?
There are two main reasons. Firstly, banks are, well, not 100% foolproof as Northern Rock demonstrated to us in 2007. Apart from the FSCS protection I hope I never need to use, if a bank fails then your money goes with it.
Secondly, with the current Bank of England base rate at 0.25% and set to fall even lower, interest rates are really not worth the effort. The current account I have with RBS is only earning 0.1% annually. The real risk here is that I’ll lose the purchasing power of my money to inflation. If we assume the standard annual inflation rate of 3% then I actually lose £29 for every £1,000 I trust with them per year. Compound interest can also work against us.
In contrast there are two reasons why you might want to consider investing. Firstly for capital growth and secondly for dividends.
Dividends are essentially a form of passive income paid out at regular intervals (monthly, quarterly, semi-annually or annually) to shareholders of a company from its profits or reserves.
They’re similar to the interest banks pay you for trusting them with your hard earned cash. The key difference is that historical data suggests you’ll be rewarded at a much higher level if you invest in the stock market than current interest rates, to compensate for that extra risk. The days of 15 – 20% annual returns are probably behind us but general consensus is that a 7% return is still very achievable.
Past performance is not a predictor of future performance and you may lose some or all of your investment.
You should also consider the way money is taxed. When I was a core medical trainee (CT1) my salary was £42,000 gross after 40% banding. I paid 20% basic rate tax and 12% national insurance for a whopping 32% tax rate. Income tax gets even higher as you hit the 40% and god forbid 45% tax brackets.
Dividends, on the other hand, are only taxed on amounts greater than £5,000 thanks to the tax free dividend allowance introduced in April 2016. That’s huge for commoners like me.
The bottom line is that dividends are a great form of passive income. But what is a dividend yield?
The dividend yield is what you’ll receive as a factor of your investment sum and this is typically expressed as a percentage. For example, if a stock or a fund has an expected annual dividend yield of 5% you can expect to receive £500 on your £10,000 investment every year.
And what is dividend reinvestment?
If you work hard, save that £10,000 and invest carefully then you can expected to be handsomely rewarded £500 every year. It’s a very neat sum of money that you can use for a new shiny iPad or a holiday. Every year.
What if I told you it gets even better than this if you delay gratification and re-invest your dividends into your initial investment and earn dividends on your dividends? Back to our old friend, compound interest:
The table above compares the amount of income you would expect to receive if you invested using different strategies. Note that it doesn’t include your initial £10,000 investment.
Dividends spent represents the cumulative amount of cash you would expect to earn on a £10,000 investment if you spent it every year or left it under your mattress. Based on a yield of 5% you’d expect to earn £500 every year in a linear fashion. In 30 years you receive a very attractive £15,000 without lifting a finger. A 150% return on your money which is massive!
At UKdoctoronFIRE we always like to go one step further. Let’s say in year 1 instead of spending it on the new shiny iPad (I just bought one but who cares about practising what you preach) you instead sensibly reinvest your £500. In year 2 you can expect to receive £525.
This is because whilst your initial £10,000 is earning you £500 annually as before, the additional £500 you earned from year 1 that you’ve reinvested is earning you £25 annually from now on too. You’re thinking to yourself that £25 can hardly pay for a meal out nowadays but by the time you get to year 30 look at the 332% return and you’ll understand why dividend reinvestment is so powerful.
Before you throw your hard earned savings at your favourite company like HSBC, Apple or BT, remember that dividend reinvestment goes hand in hand with other fundamental investment concepts such as diversification and pound cost averaging.
We’ll talk about these in a future blog post but in the meantime remember to do your own research.
P.S. I learned everything I know about finance from this book, this book and that one, amongst many others. For a more extensive list, don’t hesitate to drop me a line at firstname.lastname@example.org. If you prefer learning through listening use this link to earn a free audiobook of your choice by signing up to their 30-day free trial. Simply cancel with the click of a button if you decide later on that the service isn’t for you, no questions asked.