We live in a world of low interest rates in developed countries. Take Europe for example. Last week the European Central Bank met and decided to keep interest rates unchanged at -0.5%. Think about that for a moment. That means that you would be charged for holding euros in your bank account!
Here in the UK, we do not currently have negative interest rates. However, the base rate set by the Bank of England is only 0.75%. Back in the 1990s, rates were as high as 10%, before falling over the past decades.
Low interest rates mean that you are getting paid less for holding your cash in the bank. The economists reading this will note that this is not a bad thing, the concept is that low interest rates force people to go out and spend their money due to the low returns, helping to boost demand and get the overall economy motoring along.
But for cash holders, low interest rates are bad. So how can you generate higher returns than currently offered by a savings account or a Cash ISA?
In some ways, a stock that pays a dividend can be likened to receiving an interest payment from your invested funds. For example, let us say you invest £1,000 into a FTSE 100 company that pays a dividend of £40 a year. This is a dividend yield of 4%.
Already you can see that this is a higher return than the 0.75% base rate. Here is a key point that you need to know — higher returns often mean higher risk. While money in a Cash ISA generates lower returns, your capital is protected. With a dividend-paying stock, the dividend yield can be high, but you are risking your capital, which could decrease if the share price falls.
Therefore, while I definitely recommend buying high-dividend-yield stocks in order to generate higher returns on the amount you invest, be careful. Do your research and pick stocks that you fundamentally believe in. There is no point picking up high dividends if this is wiped out by the loss on your capital.
Stocks versus other assets
Some investors buy gold when interest rates are low. Their reasoning is that the opportunity cost of owning gold (which pays no interest) is lower when you can only pick up max 0.75% from your cash or savings accounts. However you can get exposure to gold while still picking up some form of income. For example, you could buy shares in a mining company that focuses on gold.
You pick up the dividend from the company, and if the price of gold rises, then the share price of the company will likely rise too. This way you continue to get the benefit from wanting to invest in a particular asset (this could be gold, oil, property etc), but retain the potentially lucrative dividend payments.
Overall, low interest rates can be a pain, but be smart in allocating your funds and you do not have to suffer unduly.
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Jonathan Smith has no position in any 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.