At their heart the financial markets are simply a tool with two main uses: to protect and increase your wealth. If you can train yourself to think in these terms then any fears you have about investing should disappear.
Why should you go to the trouble? If you are prepared to accept the dismal returns offered by keeping your savings in the bank then you don’t have to.
But historically low interest rates mean that cash on deposit will struggle to generate a sufficient return to outpace inflation over the long-term. Meaning if we want to protect the real value of our money then doing nothing is not an option.
Since 1962 inflation has averaged more than 6% and in order to protect your wealth you could have done a lot worse than investing in the stock market - since its inception that same year the FTSE All Share has returned an average of 7.1%.
The good news is that equities (and bonds) do not just offer simple capital appreciation - they also offer the prospect of income. By reinvesting this income investors can tap the full potential of the markets and not just guard their wealth but also boost it significantly.
EIGHTH WONDER OF THE WORLD
The power of compound interest was described by Albert Einstein as the eighth wonder of the world. How does it work? Well, if you put £1,000 into an account which pays interest of 6% you'll have £1,060 after one year. Next year, you'll be earning 6% on the £1,060 rather than just the original £1,000.
That might not seem like a big deal, but the effects can really stack up over time. How does this concept apply to the dividends from shares? A company's dividend yield is calculated by dividing its full-year dividend per share (DPS) payment by its share price.
In many ways this yield is similar to an interest payment - offering a return which is proportional to your holding. The difference compared to interest payments is that by reinvesting the income you'll be steadily increasing your holdings and setting yourself up for even greater returns down the line.
This virtuous circle can help you beat inflation and ensure the real value of your investment pot increases over time. To make this process even easier, some brokers offer Dividend Reinvestment Plans (DRIP) which allow you to use your dividend to buy new shares directly rather than receiving a cheque in the post or having your bank account credited with the payment.
For more on compounding and the impact it can have on investment performance, click here.
