I recently started investing in some dividend paying index funds on the new UK based app ‘Freetrade’ which is similar to the ‘Robin Hood’ app in the US which has been a huge success. I was previously invested
The success of applications such as Freetrade and Robin Hood lends itself to the ease with which users are able to build their portfolios without needing to go through a broker, or pay large transaction fees (which is usually a prohibitive fee unless you are buying a large number of shares).
Given that investing is becoming more accessible, we would like to discuss whether it is feasible to invest with a small amount of money.
Will I Lose My Money Investing in Assets?
If you are thinking about investing, but have never done so in the past, then it can seem quite daunting to put your savings at risk in something that you have little to no knowledge with; however, the payoff from building an investment portfolio can be significant.
I hope that with this blog post, I can help you to make your first steps into building a portfolio, and give you the confidence and reassurance that you are making the right decision.
Why Should I Invest?
If you want to create a solid fund for retirement without actually investing in a pension, then you will need to at least protect your savings from inflation.
If you put £100 in a savings account today, with a 0.5% interest rate (which is actually reasonable when compared to many savings accounts), then you will have £100.50 at the end of the year. This is a nominal increase in your wealth.
However, when we account for inflation (2.48% in 2018) which is an indication of the increase in prices of typical goods and services, you can quickly see how the nominal rise from savings interest is more than wiped out by inflation.
Your £100.50 is actually worth £98.07 in real terms. You have lost £1.93 of your wealth by storing it in a basic savings account.
Another way of rationalising this calculation is that you have £100, and this buys 100 items that cost £1.
As inflation increases the price of the item to £1.03 (3p increase from 2.48% inflation), then your £100, plus 50p interest can buy £100.50/£1.03 = 97.6 items.
You are not able to afford 100 items like the previous year, and your purchasing power has decreased.
How Can I Protect Against Inflation?
Now that you understand how inflation can eat away at your savings, what can you do to protect your money?
There are many ways that you can make your money work for you. Rather than storing your savings in a 0.5% savings account, you need to find investments, which pay at least 2.48% (the inflation rate) to break even.
You are able to invest in many assets to achieve returns in excess of inflation, such as:
- Bonds (~ 3% AER/gross)
- Stock Dividends (~ 5% Dividend Yield)
- Buy to Let (~ 5.5% rental yield)
- Peer to Peer Lending (~ 7.5% Lending Rate)
There are many potential methods to earn on your savings, but for the purpose of this post, I want to focus on the power of dividend paying stocks.
What are Dividends?
Dividends are funds that are paid out by companies, to the owners of the shares/stocks on a periodic basis.
Dividends are by no means guaranteed, but in most cases, they are stable.
If a company reduces, or removes the dividend it pays, then investors see it as a sign that the company needs to retain their profits, signalling cash flow issues.
Conversely, if a company increases the dividends paid, then investors could worry that they would need to reduce it in the future (in order to free up some profits in bad times).
Both situations would make investors worry.
As a result, stocks tend to pay a consistent dividend without much fluctuation.
Here are some typical stocks in the FTSE350 that pay dividends:
- SAGA (Insurance): 15.29% dividend yield
- GFRD (Residential Construction): 12.97% dividend yield
- VOD (Telecom): 9.44% dividend yield
This means that if you invested £100 into either of these companies, they would pay you £15.29, £12.97 and £9.44 respectively (regardless of gains you would make from the performance of these stocks).
Of course, there is always the risk that a company might decide not to pay a dividend at all (dividend risk).
Is there any way to mitigate the risk of a company not paying a dividend?
Benefits of Diversification
In non-technical language, this means ‘don’t put all your eggs in one basket’.
If you decided to invest all your money in SAGA, and expect to earn £15.29, then you could be at risk of receiving £0.
What if you decide to invest the £100 equally in SAGA, GFRD and VOD, and SAGA decides not to pay its dividend?
Then your total dividend yield would be £12.57.
This means that GFRD and VOD protect you partially from the firm specific risk of SAGA not paying its dividend.
If the risk that a firm decides not to pay its dividend is 30%, then the probability of all three firms not paying their dividend is 30% * 30% * 30% = 2.7%.
This is a diversification effect in play.
Should I Build a Portfolio of Dividend Paying Stocks?
Adding each stock you like to your portfolio individually is one way to do it, but there is an easier way: investing in an index fund, or Exchange Traded Fund (ETF).
An index fund/ETF is created by gathering multiple stocks together, and then selling shares in that collection.
This means that a fund manager could buy each of SAGA, GFRD and VOD above, and then split the resulting portfolio into three shares.
Each share would have a proportion of its value attributed to each of the three individual stocks, but with the diversification effect baked in.
There are multiple index funds/ETFs on the market, which cater to the needs of most investors.
There are dividend paying index funds/ETFs, which are collections of the dividend paying stocks (like the ones I mentioned above).
Which Dividend Paying Index Funds/ETFs Should I Invest In?
The selection of the correct fund is something that you will need to do yourself, but my favourite two are:
IUKD – iShares UK Dividend UCITS ETF
The iShares UK Dividend fund has increased by 118% in the past ten years, and it boasts a 6.7% dividend yield.
This means that a £1,000 investment 10 years ago with reinvested dividends would be worth £3,347.24 today.
IDVY – iShares Euro Dividend UCITS ETF
The iShares Euro Dividend fund has increased by 145% in the past ten years, and it boasts a 4.17% dividend yield.
This means that a £1,000 investment 10 years ago with reinvested dividends would be worth £3,695.62 today.
How Powerful Are Dividend Paying Funds for Retirement?
Let us create a hypothetical situation.
If you are 25, and have £100 to invest each month, and you choose the iShares Euro Dividend Fund above, with the listed dividend yield, and average yearly rate of return, then this is how your portfolio would grow each year:
|26||£ 1,381.29||47||£ 192,876.13|
|27||£ 2,971.27||48||£ 222,015.56|
|28||£ 4,801.46||49||£ 255,557.34|
|29||£ 6,908.15||50||£ 294,166.56|
|30||£ 9,333.12||51||£ 338,608.80|
|31||£ 12,124.45||52||£ 389,765.31|
|32||£ 15,337.49||53||£ 448,650.47|
|33||£ 19,035.95||54||£ 516,431.91|
|34||£ 23,293.16||55||£ 594,453.67|
|35||£ 28,193.55||56||£ 684,262.84|
|36||£ 33,834.29||57||£ 787,640.24|
|37||£ 40,327.21||58||£ 906,635.75|
|38||£ 47,801.08||59||£ 1,043,608.91|
|39||£ 56,404.09||60||£ 1,201,275.78|
|40||£ 66,306.83||61||£ 1,382,762.73|
|41||£ 77,705.66||62||£ 1,591,668.45|
|42||£ 90,826.61||63||£ 1,832,135.33|
|43||£ 105,929.86||64||£ 2,108,931.58|
|44||£ 123,314.88||65||£ 2,427,545.80|
|45||£ 143,326.40||66||£ 2,794,295.78|
|46||£ 166,361.23||67||£ 3,216,453.80|
This means you could have over three million pounds available for retirement from just that £100 a month put away.
Of course, this is using some strong assumptions about constant returns, and dividends staying stable, but you get the idea!
A far more conservative estimate on returns should still provide at least one million pounds for retirement.
This Seems Too Good to be True?
The fact that your modest saving each month can produce such a healthy return by retirement probably seems almost impossible, but this is the power of compounding (and precisely why the rich get richer).
If you look at the first few years that you start to invest, you are investing a standard £1,200 every year, but in five years, you would have £9,333.
This means for your £1,200 * 5 years = £6,000 investment, you have only ‘earned’ £3,333, which would seem negligible to a lot of people (and probably not worth the investment).
The real gains are happening later, due to the snowball effect of the average returns, and the reinvested dividends.
If you are receiving 10% returns in the market, and a 4% dividend yield on £100, you will get £114.
If you achieve 10% returns on the market, and a 4% dividend yield on a total portfolio size of £1m, then you will get £1.14m.
You will earn £140,000 in just a year from the market.
This is why if you look at the last three years of the table, the returns are £319k, £367k and £422k.
Is It Too Late to Start Investing?
As the example above assumes that you start investing at 25 to achieve these returns, then starting after this would have lesser results, but you should never let that put you off.
Even if you start at 35, you could still have roughly £750,000 by the time you retire.
The greatest quote I have heard is that “The best time to start investing is yesterday. The second best is today”.
Disclaimer: Investing in the stock market is inherently risky, and the returns speculated in this blog post are not guaranteed. There is the risk that the investments you make could end up losing money. Conversely, there is also the possibility that the returns could also exceed the example above.