At the start of each month, over 22m people who have ‘investments’ in Premium Bonds no doubt excitedly check their accounts to see if they have won any prizes. The sums range from smaller sub-£100 prizes to the golden goose of £1m.
Given the potential to make such a large return from your initial bond stake (it can be from as little as £25) and the fact that winnings are tax-free, many look to the bonds as a great way to potentially score capital appreciation. Some even neglect investing in stocks and put their savings into Premium Bonds instead.
But is that really the best investment strategy for your money?
Low risk, low return
One of the key benefits of Premium Bonds is that they are risk-free in nature, being backed by the government. Indeed, the only way you could lose the capital invested is if the government defaulted on the debt, which is seen as unlikely. But with this comes the flip side that the return offered is very low.
Sure, you could win the £1m prize in January, or any other month, but the chance of winning this is actually 42bn-to-one (that’s for every £1 invested). For me, this is more like a lottery ticket than an investment. If you had £1,000 invested in these bonds, then the statistics show that three in five people in your position would earn £0 over a 12-month period.
It is in fact logical that when buying a bond (which is a debt instrument) backed by the UK government, the return offered would be low as the government is unlikely to default on the debt issued. If there was a Premium Bond offered by the Argentinian government, then the returns would likely be substantially higher!
Sticking to stocks
If you were one of those in the category of earning £0 on the £1,000 invested over the past year, then investing in the stock market instead could offer you better returns. For a start, you can look to invest in a FTSE 100 tracker fund that pays out a dividend.
The average dividend yield of the FTSE 100 is currently 4.23%, meaning that you would get some kind of above-inflation return from your investment. There is no ‘luck’ in being paid a dividend. If the fund says that it will pay one, it will be paid.
But individual stocks also offer you the opportunity to see some real capital appreciation by being an active investor. Researching a particular firm you are positive about, or reading articles suggesting potential ideas, can help you get a head start as you work to boost your investment.
Contrast this to Premium Bonds, where you have no opportunity to stand out from the crowd. Everyone is in the same boat, with the same chances of winning. This limits your potential to outperform peers.
Overall, with the January Premium Bond draw just being released, don’t be disappointed if you didn’t win the big prize. Indeed, you might not have won any prize. If that is the case, then I would consider reviewing my allocation, and look to move into the stock market instead.
Jonathan Smith and 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.