As interest rates fall, should savers shift cash into the FTSE 100?

According to a well-known price comparison website, the highest interest rate available on a cash ISA is now just 1.05%.

Given that the FTSE 100 currently offers a dividend yield of 3.7%, should you shift your money into a low-cost FTSE 100 tracker fund instead?

A safe solution?

The FTSE 100 index of the UK’s 100 largest listed companies currently offers a yield of 3.7%. On savings of £10,000, that equates to an annual income of £370. This compares to just £105 each year from our 1.05% cash ISA.

For some savers, shifting cash into the stock market could be a smart move. But there are risks involved that you should understand first.

Investing, not saving

When you put money into the stock market you’re investing, not saving. Over the long term, history suggests the stock market can deliver a total return of about 8% per year. But over the short term, stock markets can be volatile. You can lose money too, at least for a while.

For example, £10,000 invested in the FTSE 100 one year ago would only have been worth only £9,220 on 12 February. Even though today, it would be worth around £10,457, in six months’ time the value will have changed again, for better or worse.

Then there’s the risk of a big crash. Between October 2007 and March 2009, the FTSE 100 fell by 48%. The market has since recovered these losses and gone on to new highs so remains the better bet for long-term investors. But if you’d been forced to sell in 2009, you’d have lost a lot of money.

This is why such an investment may not be suitable for money you may need to access at short notice.

What about dividends?

Dividend income is much less reliable than savings interest. Dividends are normally paid out of company profits, and can be cut without notice.

Although FTSE 100 companies currently offer a collective dividend yield of 3.7%, this payout isn’t covered by their earnings.

Dividend cover — a company’s profits divided by its dividend payout — is just 0.68 for the FTSE 100. That means some companies (such as BP and Shell) are having to borrow money or use up their cash reserves to pay their dividends. These companies are betting that oil profits will rise in the future to prevent a dividend cut being needed. It’s too early to say if this gamble will pay off.

Too expensive to buy?

The other big risk is that the FTSE 100 doesn’t look especially cheap at the moment. According to official figures published in the Financial Times, the FTSE 100 is valued at 40 times last year’s profits (known as the price/earnings ratio).

That’s a long way above a P/E of 12-15, at which level I’d say the FTSE was cheap.

The reason the FTSE 100 looks so expensive is that very profitable companies — such as Unilever — are currently trading at record highs. Meanwhile, other big stocks — such as miners and oil firms — are still in the early stages of recovering from last year’s big commodity crash.

For the current valuation to make sense, many of the FTSE’s largest companies need to report a sharp rise in profits next year. That could happen, but it’s far from certain.

So what's the alternative?

Rather than investing in a FTSE 100 tracker, another option is to invest in a portfolio of individual stocks. Choosing this option means you can focus on businesses with the potential to deliver profitable growth over the next few years.

You can research the companies and select those that have the best mix of stability, share price growth and income.

If you'd like some pointers to help you get started, then I strongly recommend 10 Steps To Making a Million in the Markets.

This exclusive FREE report explains how you building a million-pound retirement fund might be easier than you think.

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Roland Head owns shares of BP, Unilever and Royal Dutch Shell. The Motley Fool UK owns shares of and has recommended Unilever. The Motley Fool UK has recommended BP and Royal Dutch Shell B. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.