Whether you are investing for growth or income, you should include dividend paying stocks in your portfolio. The power of compound interest means that reinvested dividends can help grow your savings at a far faster rate than just capital growth alone. Infact, it can mean an extra 10% a year, every year – assuming a yield of 5% over a 10 year period. Auto-matically reinvesting dividends through opting for a fund’s accumulation share class takes out any human bias – you are forced to invest whatever the share price, squirreling away more units for a rainy day.
How Compound Interest Can Secure a Better Retirement
During the accumulation stage of pension saving it is incredibly important to maximise your contributions. Thanks to compound interest, savings made early on have the biggest impact. The longer you delay saving into a pension, the harder it is to make up these lost years.
A 30 year old earning £30,000 needs to invest 15% of their earnings to be able to enjoy a pension of third of their salary – £10,000 – allowing for inflation, according to calculations by Hargreaves Lansdown.
If you delay saving for retirement until the age 40 and you will need to save 21% to achieve the same level of income.
The same is true if you start investing in income paying assets early on in an investment journey and opt to these accumulate units.
“Most people are unable to afford to pay what they need to into a pension from day one, life gets in the way with other priorities. however its never too early to start saving something into pension and over time these regular contributions add up,” said Danny Cox of Hargreaves.
“Regular saving into income investments have the added benefits of the reinvestment of dividends which further boost the growth potential, helping to make a pensions mountain out of a molehill.”
Dividends: A Natural Screen for Quality
Another benefit to income investing? Determining whether or not a stock can pay a dividend is a natural screen for quality. Dividends are usually paid out of excess cash – something that only successful companies have in general. Investors should be mindful that not all dividends are funded this way however; debt has been so cheap in recent years some companies are borrowing from the bank to pay out to shareholders. You can check if a company’s dividends are covered, meaning they are paid out of cash, and sustainable, by checking a company’s dividend pay-out ratio. This is the dividends and buybacks added together, divided by the profit for period. These figures can be found on a company’s report.
Rewarding shareholders with dividend payments – or indeed share buy-backs – also shows that a company’s board has aligned interests with shareholders. This prioritising of shareholders is indicative of good corporate governance – in fact it is one of the screens applied to the new Nikkei 400, a “shame” index of Japanese funds which only includes companies on the basis of good governance.
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