The secret to becoming rich

The secret to becoming rich is much simpler than you might think.

When journalists write about house prices or the stock market, they  normally focus on big changes in price – whether it be soaring values for luxury houses in London or collapsing share prices for over-indebted banks.

But actually those reports only tell half the story. Yes, a company’s share price is important, but the amount of income a company pays to its shareholders is just as important.

If you don’t believe me, look at these figures from the Barclays Equity Gilt Study 2011. They show how an investment in the UK stock market has performed since the end of World War 2.

Today’s value of £100 invested at the end of 1945 without reinvesting income

The above figures show that if you had invested £100 in the UK stock market in 1945, your investment would be worth £7,932 in by the end of 2010.

That sounds great, but the number doesn’t take inflation into account. Prices have risen a lot since World War 2, so the inflation-adjusted return on your investment is much lower - just £255. In other words, your investment has increased in value by 150% over 65 years. Not a great return for such a long period!

However, the above table doesn’t take income into account. The majority of companies on the stock market pay dividends to shareholders every year and these dividends can really supercharge the returns you receive on your investment.

Take a look at this table:

Today’s value of £100 invested at the end of 1945, gross income reinvested:

If you had reinvested all your dividends since 1945, you’d have turned £100 into £136,107. Once you take inflation into account, the final figure is £4,370 – far better than the £255 nest egg you’d have if you hadn’t reinvested all your dividends.

The message is clear – if you want to make money from the stock market, income is really important. And if you reinvest the income, you can gradually become rich. 

So if you want to get good income from the stock market, what is the best way to do it?

Index tracker funds

The obvious place to start is conventional index tracker funds. (These are funds that track the performance of a particular index at low cost.) You’ll get a nice income and it’s very easy to reinvest the dividends. All you need do is tell the fund management company that you want to reinvest. Just so you don’t get confused by the jargon, people who reinvest dividends sometimes have ‘accumulation units’ in a fund.

Above average income

However, if you want to get an above average income from your stocks and shares, there is a cheap option. You could buy shares in a fund called the iShares FTSE UK Dividend Plus. 

Here’s how it works. The 350 largest companies on the London market are known as the FTSE 350. Instead of investing in all 350 companies, this Dividend Plus fund only invests in the 50 companies that have the highest ‘yield.’ In other words, the fund invests in the companies that pay the biggest dividends as a percentage of the share price.

Neil Woodford

Another option is to go for a managed income fund where an investing ‘expert’ is paid lots of money to pick shares with high dividends. In reality, most of these managers aren’t worth the fees that they charge but there is one possible exception. His name is Neil Woodford and he has a very strong track record over the last 20 years. Find out more about the funds he manages here.

Not just shares

I’m in no doubt that income is also really important if you invest in property or bonds. One of the downsides of property is that you have to use some of your rental income to maintain the property, but rent can still be a significant earner for landlords.

The crucial point is that ‘get rich quick’ schemes probably won’t make you rich. If you buy land in the hope that it will get planning permission, it probably won’t. If you buy shares in a new technology company that is supposedly going to change the world, it’ll probably go bust in the end.

But if you’re prepared to be patient, and not spend your investment income, you can be rich in the end.

More:  Two simple ways to invest better in shares  |  Don’t listen to dodgy financial advisers | The best way to build wealth