Over the last few years, dividend investing was the only real way to generate any kind of meaningful passive income. But that seems to have changed.
Savers can now get 6% on a one-year fixed rate account. So with the FTSE 100 having an average yield of just under 4%, are dividend stocks still worth it?
Returns
At first sight, the question looks like a no-brainer. Keeping money in cash looks like a higher reward for less risk.
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Getting a 6% return on £20,000 in a savings account would yield £1,200 in interest, compared to £800 from a 4% dividend from the FTSE 100. And reinvesting those returns amplifies the difference.
Reinvesting an initial £20,000 at 6% for 10 years would result in an account worth £35,817. At 4%, the end result would be just £29,604.
All of this is true, but I think it misses an important point. Interest rates on cash accounts might well fall over time, whereas the amount the best dividend stocks return to shareholders is likely to go up.
Interest rates
The above calculations depend on being able to earn interest at 6% per year for 10 years. And it looks to me like there’s a good chance this won’t be possible.
Analysts at JP Morgan are expecting UK interest rates to peak next year at just above 6%, before coming down. By 2028, the forecast is for them to be back below 4%.
If that happens, UK savers are unlikely to be able to get 6% on cash savings each year for the next decade. Five years from now, I expect the rate to be significantly lower.
Even if this estimate isn’t quite right, I think there’s a good chance interest rates will be lower than they are now at some point in the next decade. And that’s likely to cause returns from savings to fall.
Dividends
The big risk with dividend stocks is companies might be unwilling to maintain their payments, or else decide not to. But with the best businesses, this risk is relatively low.
Furthermore, with the best stocks, the amount shareholders receive has gone up over time. Unilever, for example, has a strong record of increasing returns to investors.
The stock currently has a dividend yield roughly in line with the FTSE 100. But over the last decade, the company has increased its distributions by around 5% per year on average.
Over the next 10 years, I think getting a 4% return from dividend shares is much more likely than earning 6% interest on cash. And I feel this is a compelling reason to stick with stocks.
Buy now or later?
One last idea might be to keep money in cash until interest rates start falling and then switch to dividend stocks. But I don’t think this is a good plan.
When interest rates come down, the price of stocks might well go up – this is often the case with share prices. So the yield on dividend stocks might well be lower than it is now.
For me, the way forward is clear. My plan is to enjoy earning a higher rate of interest on the cash I keep for emergencies, while continuing to invest in the stock market.
