What do you think is the safest way to hold money? If you ask the average person, chances are they will tell you that they prefer to hold their capital in cash. They will point to the relative stability of the value of the pound, and contrast it with the frequent swings seen in stock prices.
Yes, interest rates right now are at all-time lows. You would be lucky to get 2% on a promotional account with restrictions on maximum deposits. But at least you can be relatively certain that that £1,000 sitting in your savings account will be worth as much a year from now.
However, on a larger time frame, this security turns out to be an illusion. Since 1980, the UK has experienced total price inflation of 425%, meaning that what used to cost £1 in 1980 costs £4.25 today. Think about that. If you set aside £1,000 in the early 1980s, that sum would be worth less than £250 today. So the ‘safety’ of cash is entirely illusory.
Yes, cash savings do not experience the kind of volatility that can make stock investing seem daunting to novice investors. But would you rather put your savings into something that grows in value over time, or something that loses value over time? I think the answer is obvious.
Incidentally, the value of bonds erodes in a similar fashion, because the income streams they provide are fixed, and so over time they will lose their value as the value of the pound falls.
This is why I think that people who are saving for their retirement would be better-served by building up a diversified portfolio of stocks, purchased at cheap valuations. The second part of that sentence is particularly important, because your wealth will only compound if you do not lose money.
How do you do this? There are a number of metrics that you should be looking at when choosing stocks for your portfolio. The simplest one is the price-to-earnings (P/E) ratio. All other things being equal, you should target companies whose stocks are trading at lower P/E ratios than their peers, as this indicates that you are getting value per pound spent.
Dividend yield is another important factor to consider. Not all stocks pay dividends – nor should they – but for those that do, you should pay close attention to them. While it may be tempting to jump at a stock with a double-digit yield, an excessively high yield is sometimes a sign that the company is in trouble (because investors are wary about buying it). It can also be a sign that the market expects a dividend cut in the near future.
Investing isn’t the easiest thing in the world to do, but if you make sure to remember that the mathematics of stock investing is in your favour, you will be better-placed to succeed. Make sure to buy high-quality stocks at cheap prices and watch your retirement pot grow.
Of course, picking the right shares and the strategy to be successful in the stock market isn't easy. But you can get ahead of the herd by reading the Motley Fool's FREE guide, “10 Steps To Making A Million In The Market”.
The Motley Fool's experts show how a seven-figure-sum stock portfolio is within the reach of many ordinary investors in this straightforward step-by-step guide.
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.