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Why I’d invest £3,000 in a FTSE 100 index tracker and never sell

My colleague Peter Stephens pointed out last month that investing in a FTSE 100 index tracker fund 10 years ago would have delivered a decent return by now. With dividends reinvested along the way, he estimated a £1,000 investment would have turned into around £2,150 by now.

That equates to an overall annualised return of around 8%, and knocks the spots of what we could have gained by stashing our money in just about any cash savings account. I reckon the FTSE 100 will likely make a decent base investment in the years ahead too. To me, the index is a good way to harvest dividend income and, right now, it’s yielding somewhere around 4%.

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Dividend income can juice up returns

And it’s the income from the dividend that can really juice up your returns from the index. Over the past decade, the Footsie has risen about 46%, but those reinvested dividends compounded to produce the outcome Peter illustrated in his article.

With index tracker funds, it’s easy to reinvest dividends. If you select the Accumulation version of the tracker, it will automatically reinvest the dividend income for you. The alternative would be the Income version of the fund, which would pay the dividend income into your bank account. But if you’re aiming to build wealth, I’d recommend reinvesting the dividends to compound your gains.

One of the major advantages of choosing to invest in a tracker fund, instead of investing in the shares of individual companies, is that you gain instant diversification. Indeed, your investment will be spread over the shares of around 100 individual companies with a FTSE 100 tracker fund. That practically knocks out the big risks you’d take if you put all your money into the shares of just one or a handful of individual companies.

How to handle the volatility

But one criticism I’ve sometimes heard about the FTSE 100 index is that it’s filled with a high proportion of firms in cyclical sectors, such as banks, miners, retailers, and the like. And that’s true. But cyclical stocks often tend to pay the highest dividend yields and I reckon the main advantage of investing in the lead index is the dividend income.

However, cyclical shares tend to move up and down a lot, and we can see big swings in the FTSE 100 over several years to illustrate the point. Yet despite its dips, the index has always (so far) bounced back up again. And over the long haul, the trend is up.

One way to handle the volatility of the index is to refrain from investing all your money, say £3,000, in one go. That’s because you may catch a peak in the index and end up investing at the cyclical highs. To me, a better idea is to invest regular monthly sums, which means you’ll also be investing in the cyclical troughs and getting more units for your money.

Such pound/cost averaging could work to smooth out the volatility in your investment. So I’d split £3,000 into 12 monthly investments of £250, then repeat the investment programme every year and never sell! 

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Kevin Godbold has no position in any share 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.