It should come as no surprise to anyone that the State Pension is not enough to provide for a good retirement. If you agree that £168.60 a week is not enough to live on comfortably, then you will probably be thinking about other ways to increase your retirement savings.
It is important, of course, to have an adequate amount of cash to retire comfortably, which is why you should be putting money aside every single month. I believe that you should be saving at least 20% of your income, and some people put that number even higher at 30%.
But cash on its own barely grows these days. Over the past few decades – and especially since 2008 – interest rates have come down to the point where putting cash into a savings account and hoping to live off the interest it generates is no longer a reasonable strategy.
Therefore, if you want your money to work for you instead of sitting idle, you need to look elsewhere.
The data shows that investing your savings in the stock market is the best way to grow your retirement pot. On average, the compound annual return of the FTSE 100 over the last 25 years has been 6.4%, assuming reinvestment of all dividends.
This means that if you had invested £100,000 in the FTSE 100 25 years ago, that investment would be worth £471,561 today. Of course, this number would be much larger if you had consistently added to your investment portfolio.
Better still, these are just the average returns for the FTSE 100 – by tailoring your portfolio correctly you can achieve even better results.
Is yield the most important thing?
So how does one go about finding the best dividend stocks to invest in? Many beginner investors make the mistake of going for the stocks with the highest dividend yield – that is, those that pay out the most in dividends relative to their share price.
While a stock with a yield of 10% or more can seem enticing, in reality, many high-yielding stocks have serious systemic issues that – in the long term – will make them more trouble than they are worth.
Firstly, a high yield is often a sign that the current dividend is unsustainable, which may mean that management will soon reduce payouts to investors. Secondly, a company that is paying out too much of its cash is, by definition, not reinvesting that cash efficiently. This can lead to the company’s stock price falling, which will ultimately damage your returns.
Remember: investing in income stocks is not just about receiving regular dividends, it’s also about making sure that the value of the investments themselves does not decline. For this reason, I consider total return to be a more important metric than dividend yield.
Total return is the sum of interest, dividends, and capital gains of a given investment. This gives you a much more complete picture of what the real return on an investment will be.
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Neither Stepan nor The Motley Fool UK have a 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.