For most of us, the main point of investing is to build a pot of money that will provide us with a comfortable lifestyle in retirement.
Some people find it hard to get their heads around this idea. The future seems so distant, and so unknowable, and the sums bandied about so huge, that there seems no point in even trying to save.
It doesn't help that there's a whole industry of asset managers with an interest in making it look very complicated so that you feel obliged to hand your savings over to them in exchange for a hefty fee.
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
But the truth is, building a decent retirement pot isn't that complicated. In fact, I'm going to explain everything you need to know.
The three things you need to build yourself a retirement pot
There is a proven way to build your wealth that requires three main things.
Assets that generate meaningful income streams;
The reinvestment of the income;
What we're talking about here is using the power of compound interest (earning interest on interest) over a period of at least 20 years, to do all the hard work for you.
It's said although no one knows for sure - that Albert Einstein once described compound interest as the eighth wonder of the world. When we show you what dividend re-investment and compounding can do for your savings pot, you may feel inclined to agree.
Building a portfolio that can meet your future income needs takes a bit of effort to set up. But once you've done it, it just needs monitoring.
Let's be clear: this is not a strategy for those who want to get rich quick, or who are seeking instant gratification from the stock market.
This is a strategy for income that is mostly independent of the casino-like workings of today's stock market. It also gets you to focus on the underlying businesses or assets that produce the income you are seeking, rather than constantly agonising over yo-yoing share prices. What happens to the capital value of your investments is of secondary importance.
Let's get started.
First, you select around 10-15 investments from different sectors of the economy. This is to ensure that you adequately diversify your risks. One caveat here: we are ignoring sectors that we don't properly understand or which are highly leveraged (such as banks) and also cyclical industries (such as mining companies).
Instead, we are looking for companies that are capable of maintaining or growing their dividends under most economic scenarios.
Once selected, you put an equal amount of money into each investment. There is no benchmarking here. We're not trying to outperform an index, just grow our future income.
Below, I've put together a sample portfolio of 16 companies from different sectors of the UK stock market. (I've changed the names as I don't want to get into specific stock tips here instead I want to show you the maths behind this strategy) with their current dividend yields and dividend cover ratios.
|Mobile Phones Limited||Telecoms||5.40%||1.6|
|Bob's General Store||Retail||5.10%||2.1|
|Buses & Trains||Transport||4.80%||2.8|
|Drugs and Medicine Co||Pharmaceuticals||4.80%||1.6|
|Insurance Company prefs||Insurance||7.00%||46.2|
|Land & Property Rentals||Property||5.20%||2.1|
|Bill's Cleaning Products||Household Goods||3.70%||2|
|The Food Making Company||Food Producers||6.20%||2.4|
|Cranes and Co||Construction||6.10%||1.9|
|The Local Boozer||Restaurants||4.60%||2.1|
|Cakes & Pies||Food Retail||3.90%||2|
|Gas & Electricity Works||Utilities||4.90%||1.7|
|The Oil Company||Oil||4.80%||3.1|
All I'm hoping for here is that the underlying businesses are good enough to maintain their current dividend payouts. If they increase, that's all well and good, but it's not important for this strategy to work.
Now see what happens if we hold this portfolio for 20 years and invest £5,000 in each stock. We assume that the share prices don't change, that the dividend payment remains constant throughout, and that you reinvest all dividend payments.
|Mobile Phones Limited||5,000||269||5.40%||728||14.60%||14,256|
|Bob's General Store||5,000||256||5.10%||661||13.20%||13,574|
|Buses & Trains||5,000||241||4.80%||590||11.80%||12,825|
|Drugs and Medicine Co||5,000||239||4.80%||578||11.60%||12,701|
|Insurance Company prefs||5,000||348||7.00%||1249||25.00%||19,195|
|Land & Property Rentals||5,000||258||5.20%||673||13.50%||13,700|
|Bill's Cleaning Products||5,000||186||3.70%||372||7.40%||10,379|
|The Food Making Company||5,000||309||6.20%||966||19.30%||16,595|
|Cranes and Co||5,000||307||6.10%||954||19.10%||16,482|
|The Local Boozer||5,000||231||4.60%||545||10.90%||12,339|
|Cakes & Pies||5,000||195||3.90%||405||8.10%||10,761|
|Gas & Electricity Works||5,000||247||4.90%||618||12.40%||13,125|
|The Oil Company||5,000||238||4.80%||575||11.50%||12,667|
What you can see in action is the power of dividend reinvestment and compound interest over time. Your £80,000 initial investment provides you with an annual income of £10,443 or a yield on cost of 13.1%. The value of your capital has increased to £213,608.
Hold for 30 years and you get an annual income of £17,226 or a yield on cost of 21.5%. The value of your capital would be £352,784.
As you can see from the table, the higher the starting yield, the better the long-term results. Obviously, you have to be careful not to buy stocks with yields that are unsustainably high. But if you preferred, you could put together a portfolio of higher-yielding utility companies for example, and get a better return than in the example above. It's up to you as to how much diversification you want.
A better, cheaper approach to investing
Once you've done your homework and selected good companies with decent, sustainable dividend yields, you can put your fund on autopilot. All you have to do is to keep monitoring the health of the businesses you have bought can they keep paying you a dividend? As long as that's the case, there's no need to worry about the daily movements of share prices.
For me, this is what investing in shares is all about and it's how I manage my own portfolio. The other good thing is that it's not expensive.
You are not paying an annual management fee of 1.5% plus other hidden expenses as you would with an equity income fund. And most stockbrokers will allow you to set up a dividend reinvestment option on FTSE 350 stocks. For example, TD Direct Investing charges only £1.50 commission for the reinvestment of dividends.
You also learn to love falling share prices because it allows your reinvested dividends to buy more shares and with it more income.
If this method of investing appeals to you, you can have a crack at building your own income portfolio. But before you do, you should take a look at 'The Dividend Letter' newsletter, written by my colleague, Stephen Bland. Stephen couldn't care less about where the stock market is going he just looks for good, income-producing stocks. He's already built three high-yield' portfolios and will soon be starting on his fourth.
In a jittery, news-driven market like this one, this strikes me as the perfect way to invest and still sleep soundly at night. Take a look at his three-minute pub rant here, where he explains why so many investors lose money, and how you can avoid doing it.
This article is taken from the free investment email Money Morning. Sign up to Money Morning here .
Our recommended articles for today
Should you buy Severn Trent's index-linked bond?
Utility company Severn Trent is launching an inflation-linked bond for retail investors. Phil Oakley examines whether you should buy it, or stick with the company's shares.
How to make money while stealing business from the banks
Low interest rates for savers and tight credit for borrowers have given a huge boost to peer-to-peer lenders, which cut banks out of the lending process. So should you take the chance to play bank manager yourself? Matthew Partridge investigates.
Phil spent 13 years as an investment analyst for both stockbroking and fund management companies.
After graduating with a MSc in International Banking, Economics & Finance from Liverpool Business School in 1996, Phil went to work for BWD Rensburg, a Liverpool based investment manager. In 2001, he joined ABN AMRO as a transport analyst. After a brief spell as a food retail analyst, he spent five years with ABN's very successful UK Smaller Companies team where he covered engineering, transport and support services stocks.
In 2007, Phil joined Halbis Capital Management as a European equities analyst. He began writing for Moneyweek in 2010.
Follow Phil on Google+.
Trading terms: The Santa Rally
Glossary Will the Santa Rally result in its traditional December effect on global markets?
By Dr Matthew Partridge Published
Lock in high yields on savings, before they disappear
As interest rates peak, time to lock in high yields on your savings, while they are still available.
By Ruth Jackson-Kirby Published