Investing should be simple: you try to put your money into cheap assets that will grow in value over time, and after a number of years, you hope to have enough money to live on, or to buy something that you want.
But something’s gone wrong. We are constantly bombarded with information about economies and companies. So the stock market behaves like a manic-depressive – up one day, down the next. As a result, as countless studies show, we trade too often and lose huge amounts of money in fees and other charges.
It doesn’t need to be like this. Here are two simple, common sense strategies that will help you keep your head while others lose theirs.
Use the power of compound interest
If you allow it the time to do its work, the power of compound interest (earning interest on interest), can grow your money pretty painlessly.
If, like me, you’re a conservative investor, then you aim to put your money in assets where a large chunk of your returns is independent of the market’s mood swings. You focus on income rather than capital gain – in other words, you are looking for large dividend payments on shares, chunky rents on property or big coupons on bonds.
By buying assets like this and reinvesting the income you harvest from them, you can build up your savings pot substantially – as long as you’re patient. Once you’ve found the right asset, sit back and let the power of compound interest work for you.
Take utility company National Grid (LSE: NG/). At 678p it pays an annual dividend of 39p per share, giving it a yield of 5.7%. Let’s assume for the sake of argument that National Grid pays 39p per share forever, and the share price goes nowhere for the next 20 years. If I buy 1,000 shares and reinvest my dividends every year, my initial investment of £6,785 trebles to £20,749 at the end of 20 years. My annual dividend income is £1,128, giving me a yield on my initial cost of 16.6%. That’s not too shabby.
Of course, this doesn’t mean that you just go out and buy the highest-yielding assets on the market. A crucial part of this approach is the ability of the asset to keep paying a decent yield. It’s no good opting for a stock that’s apparently yielding 10% if it then has to scrap or cut its dividend. My colleague Tim Bennett looked at three ways to ‘stress test’ dividends earlier this year.
Another option is to invest in preference shares, which are somewhere between a share and a bond. Obviously, preference shares are not risk-free by any means – the capital value goes up and down just like any other investment, and there’s always bankruptcy risk. The shares can be less liquid than standard equities, too. I’ve written in more detail about the risks around preference shares here: Seeking income? Try these four preference shares.
What’s interesting for income investors is how dividends on preference shares are paid. The dividend on a preference share is usually fixed – so it won’t rise over time, as you’d hope for with an equity. However, preference shareholders are first in line for dividend payments. A company can’t pay out to ordinary shareholders unless the preference dividend has been paid first.
One option I’ve suggested before is the Royal Sun Alliance 7 3/8% (LSE: RSAB) preference share.
Forget about timing the market
The other way to stop yourself from being distracted by panicky markets is to ‘pound-cost average’. This is a slightly clunky description for something very simple, but it just means investing money at regular periods such as once a month, rather than a lump sum all at once. This can be a particularly good strategy when markets move up and down a lot as they are doing at the moment.
There’s no evidence to suggest that pound-cost averaging works better than lump sum investing in terms of performance. Last year, the Association of Investment Companies compared the results from making regular savings with those of investing lump sums at various points. The outcome was mixed: they found that in bear markets, regular savers did better, but over longer periods, lump sums won – provided you got in at a sensible entry level.
But that’s the catch. The fact is that very few of us are smart enough to call market tops and bottoms; the advantage of a drip-feeding strategy is that you don’t need to worry about this as much. It also it forces you to stay invested so that you take advantage of cheap prices.
Most brokers can set up regular investment and automatic dividend reinvestment plans for you. Then you can shut down your computer and resist the temptation to be swayed into trading by the market’s short-term mood swings.
• This article is taken from the free investment email Money Morning. Sign up to Money Morning here .
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