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It may seem like a pipe dream to have a million-pound investment portfolio before you retire. Of course, it can’t be achieved overnight, but with careful planning and regular savings, it’s more attainable than you might think.
Savvy investors can make their investments take off like a rocket by harnessing the power of dividends and reinvesting them over time, rather than spending them. An investor who had invested £500 a month in the UK stock market for the past 40 years would have a pot of £1.4m today – but that was only if they had reinvested the dividends they had received.
Without this, it would be worth a less impressive £506,000, according to investment platform Bestinvest.
Investing wisely when you’re young could make a big difference in your retirement
The current high yields in the UK mean that those who have time on their side and choose the right funds to benefit from the magic of compounding can make a million pounds. This is the snowball effect that increases the value of portfolios as the money is reinvested.
The UK stock market is fertile hunting ground, with some shares offering a yield of over 9 per cent, meaning a cash payout of £9 a year for every £100 invested.
These payments have delivered a bigger return for UK investors than any rise in share prices. Jason Hollands of Bestinvest says: “When these payments are reinvested in shares rather than sitting in the bank, the effect is particularly powerful.”
How can you get started today if you want to hit the £1 million mark? Many well-known British companies offer dividend payouts that dwarf the returns offered by a bank account.
These include insurance firms Legal & General and Phoenix Group, which offer returns of over 9%. An annual return of 9% would give you a £1m portfolio in just 31 years, but Hollands warns against simply picking the highest-yielding stocks now and hoping to become a millionaire over time.
Compound interest is a great way to grow your money
“It is unwise to select a fund or stock based solely on a high dividend yield, without first checking that it is sufficiently covered by earnings and that the dividend is not at risk of being cut,” he says.
Instead, he suggests starting by using funds that invest in high-yielding stocks with solid business prospects to build a million-pound portfolio. And always make sure you tick the right boxes to ensure your dividend helps your money grow.
Make a plan that you can follow
Setting out to become a millionaire from dividends is a long-term endeavor. Make sure you’ve set everything up correctly from the start to give your money the best chance of growing over time.
That means choosing an investment platform that gives you access to the funds you’ll be purchasing and with the lowest fees.
Then set up a regular payment into your chosen funds and make sure you have ticked the correct boxes for the dividends to be reinvested.
Most platforms allow you to set preferences to automatically reinvest any dividends paid by exchange-traded funds, stocks, or investment trusts.
If you buy other types of funds, make sure you choose the “accumulation” rather than the “income” units of the fund. This means that any income paid out from these will be automatically reinvested.
To avoid dividend tax, charged at 8.75 per cent on any dividend over £500 for basic rate taxpayers (33.75 per cent for higher rate taxpayers), set up an ISA for your dividend portfolio.
Choose the right funds for safe returns
While buying high-yielding individual shares from the FTSE 100 index is a tempting way to take advantage of the compounding effect of dividend payments, there is a danger that the companies behind them will stop paying dividends and that yields will fall over time.
“Dividend yields are not fixed and vary from year to year based on the share price as well as actual payouts,” Hollands cautions. If you buy individual high-yield stocks, check that the company can pay its dividend using a measure known as “dividend cover.” This measure divides earnings per share by dividend per share and shows how many times a company could afford to pay its dividend from its earnings. A low measure suggests a company may struggle or cut its dividend later on.
Buying a high-yield fund or series of funds can be a safer way to build your portfolio.
Alex Watts, a data and fund analyst at investment platform Interactive Investor, says active managers who focus on dividend-paying companies can ensure that these are “financially sound and generating enough cash flow to maintain or increase distributions.”
He suggests investing in Artemis Income, which offers a 3.4% yield but also focuses on capital growth. The fund is up 27% over the past three years, as well as distributing cash. “The fund’s management has a clear ‘cash flow first, dividends second’ mantra – in short, they prefer to invest in companies that can consistently generate strong cash flows, which is key to fueling the dividends that shareholders receive,” he says.
Laith Khalaf, senior financial analyst at investment group AJ Bell, suggests buying the City of London investment fund, which focuses on dividend growth. The fund offers an annual yield of around 5% and has seen 57 consecutive years of dividend increases.
The trust, which has grown by 26 per cent in the past three years, has been run by Job Curtis since 1991 and focuses on large-cap UK companies.
Rob Burgeman, senior investment manager at wealth management firm Brewin Dolphin, suggests Murray Income, another investment fund. He believes these funds, which are publicly traded and can retain some profits in good years to pay out in lean times, are attractive to anyone looking to build a dividend portfolio.
He says: ‘They maintain decent levels of reserves to smooth out the income they provide during difficult periods; there are many considered ‘dividend heroes’, having increased their dividend every year for 50 years or more.’
Murray Income has returned 281 per cent on a capital basis over the past 35 years, but with dividends reinvested it has returned 1,498 per cent, Burgeman says.
The trust focuses on large UK companies such as Unilever, AstraZeneca and RELX.
Use a pension to save faster
Follow Albert Einstein’s advice on interests
Tapping into the power of your pension could enable you to reach millionaire status much more quickly. This is because the Government allows tax relief on any contributions made at your marginal rate of income tax, whether you are a basic, higher or additional rate taxpayer.
A £500-a-month contribution to a SIPP means a £250 tax reduction for those paying 40 per cent tax. Add this up and assume a 6 per cent annual growth rate, with dividends reinvested, and you’d be a millionaire in 35 years.
If a 9% return could be achieved (as currently offered by stocks such as Phoenix and L&G), the magic million could be reached in less than 28 years. Of course, all this depends on there being no major changes in the next budget.
Use the power of time to grow wealth
Albert Einstein called compound interest “the eighth wonder of the world.” And you may find plenty of reasons to marvel at the cumulative power of dividend reinvestment.
Staying on track for decades means you could end up with a huge sum before you retire, with most of it coming from dividends, rather than share price growth.
Stock Market Codes
Artemis Income: B2PLJJ3
Murray’s income: 0611112
City of London Investment Trust: 0199049
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