While living within your means is a worthwhile move that provides you with capital to fund your retirement plans, holding excess capital as cash could prove to be an unfavourable idea.
Certainly, it may mean that you do not lose money. However, it is unlikely to bring your retirement date much closer. After all, inflation is ahead of interest rates, which means that the spending power of your savings is falling.
As such, investing in FTSE 100 dividend shares could be a better idea. They provide the potential to earn capital growth alongside an income return that is currently many times higher than the interest rate on cash savings.
While the FTSE 100’s dividend yield of around 4.3% may be around three times higher than some of the most appealing interest rates on cash savings, large-cap shares also offer dividend growth potential.
Over the long run, the dividend growth provided by FTSE 100 stocks could be significantly higher than inflation. After all, the world economy continues to grow at a relatively fast pace. And, while there may be risks ahead in the short run, history shows that over the long term, many companies are able to produce dividend growth that not only increases income returns for their investors, but also raises demand from other investors for the stock in question.
The result of this can be a high level of capital growth. This may be especially relevant at the present time, when investors may demand companies that are able to provide them with a high and fast-growing dividend in order to counter low interest rates.
As mentioned, dividend stocks are riskier than cash savings due to there being the potential for loss. However, investors can counter this threat through diversification. This could be through buying companies that operate in different parts of the world, as well as in different sectors. Having a diverse range of stocks in a portfolio can lead to reduced company-specific risk, which is the prospect of poor returns from one stock negatively impacting the wider portfolio.
In addition, selecting shares that have highly affordable dividends could be a means of reducing risk. For example, a business that has dividends which are covered twice by profit, and that has a solid track record of dividend growth, is likely to be less risky than a stock that pays almost all of its net profit to shareholders. As such, through buying the most appropriate stocks given your level of risk, you may be able to create a highly appealing risk/reward ratio in order to improve your retirement prospects.
Clearly, holding some cash is a sound idea. It provides peace of mind, as well as capital to invest during opportune periods for the stock market. But relying on it in order to provide an early retirement seems to be a relatively unfavourable option compared to buying dividend stocks.
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Peter Stephens has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.