This guide explains why dividend stocks with lower yields can still be worth investing in, what factors matter beyond yield, and how long such high rates on cash really last.
If you’re asking:
“Why should I invest in dividend stocks yielding 3-4% and take the risk if simple cash is paying 5% or higher?”
Or
“How does inflation affect the ‘safe’ returns I get from a high-interest bank account over the long term?”
Then you’re in the right place.
Key Takeaways
- High cash interest rates don’t automatically make dividend investing unattractive.
- Dividend yield alone is an incomplete way to compare cash and stocks.
- Dividend growth and capital appreciation play a major role in long-term returns.
- Elevated savings rates are usually temporary, not permanent.
- Cash suits short-term goals, while dividends are better for long-term investing.
Dividend Stocks vs Cash: Dilemma
At the time of writing, the Bank of England rate is at 5.125%. This rate is quite a bit higher than it has been for the last 10 years or so.
As this is a relatively novel concept for a lot of investors, it causes a puzzling dilemma.
On the one hand, where bank rates have been low, dividend stocks have seemed like a natural choice.
If your bank barely pays 1%, then a company paying 4% or more seems like a great option to get some income.
However, cash is perceived as risk-free in that the nominal amount doesn’t go down, or you can’t lose it on the market, and you know where you stand with the interest.
Does that mean that we should all ditch our sub-4% yielding portfolios?
Are there benefits to investing in the stock market and risking your portfolio amount going down?
Let’s take a look.
Reference Point for Cash
First of all, we’ll use 5.2% as a reference point for cash.
Some accounts have higher amounts, but they usually have some hoops to jump through, such as:
- Only being allowed to deposit a certain amount
- Moving money around in order to get the bonus
- Leaving it locked in place for one or two years at a time
We’ll base it on 5.2% as I know that right now you can get 5.2% on uninvested cash with Trading 212. Rates may change in the future, but this is accurate at the time of writing.
You can get 5.2% on cash, the amount you put in won’t go down, and you can predict exactly how much you’re going to get at the end of the year of holding it.
Conversely, a dividend stock that pays 3% pays less out by the end of the year, and you have no true idea if it’ll be up or down by the end of the year either.
Buying a dividend stock that yields 3% instead of cash is often justified because yield is just one part of the equation.
There are more factors involved when buying dividend stocks.
Exxon Mobil (XOM) Example
Exxon Mobil (XOM) is a very common stock that dividend investors likely hold, and with a yield of about 3%, it fits nicely as an example.
It has a dividend yield of 3.14% and therefore pays less than the 5.2% cash.
If we only look at yield, it’s an easy choice. However, there are several key factors to consider.
The Power of Dividend Growth
In 2014, Exxon paid a total of $2.76 per share for the year, distributed in quarterly payments of $0.69.
Now in 2024, 10 years later, Exxon paid $3.80 a share per year, or 95 cents per share per quarter.
This steady increase demonstrates the concept of dividend growth.
Dividend growth is the increase in dividends paid out by a company over time, indicating its financial stability and performance.
This trend is often sought after by investors as it signals a commitment to shareholder value and a potential for future growth of the company.
The dividend growth rate, which measures the percentage increase in dividends over time, is a key metric for investors evaluating companies’ dividend policies alongside other factors.
However, yield and dividend growth are not the only factors that need to be taken into account.
Capital Appreciation
Back in 2014, Exxon was trading at $96, but if you were to buy it today, it would cost $121.
That means it’s increased 25% in that time, as well as paying out the dividends for the whole duration. In fact, just since the start of this year, it’s up about 18%.
If you looked at yield alone and compared the cash of 5.2% with a yield of 3%, you would have missed out on the potential for capital appreciation (stock price growth) too.
Longer term, the amount each share pays hopefully will increase as well. Comparing yield with interest on cash is too one-dimensional.
However, this doesn’t guarantee that dividends will perform better than cash. Two main risks exist:
- Dividend Cuts: The company cuts the dividends, meaning you actually get less income rather than growth.
- Capital Loss: The company falls in value, so whilst paying you a dividend, your principal investment is worth less than when you started.
Obviously, we want to avoid either of these events, and that is part of the trick of investing.
In comparison to the cash receiving 5.2%, it’s all a trade-off of risk that you’re willing to take.
How Long Should You Invest?
If you’re planning to keep the money invested for less than 5 years, then the general recommendation is to keep it in cash.
There may not be enough time for your investment in stocks to recover if there’s a downturn.
This isn’t financial advice—just a generally accepted thought on the difference.
How long will these interest rates on cash really last?
The Bank of England (similar to other central banks) has a responsibility to keep the economy on track.
One of the most significant aspects they have to monitor is inflation, which occurs when prices rise over time.
The Inflation Balancing Act
When prices of items such as groceries and petrol increase too rapidly, it indicates an excess of money circulating in the economy.
One of the main tools the Bank of England employs to manage this is interest rates.
How Rising Interest Rates Help Cool Down the Economy
When inflation starts spiralling out of control, the Bank of England might decide to hike up interest rates.
When interest rates rise, borrowing money from banks becomes more expensive. Consequently:
- People might think twice about taking out loans for things like homes, cars, or launching new businesses.
- Businesses might also scale back their spending because borrowing money for investments becomes pricier.
This reduction in spending and borrowing puts the brakes on the economy, and when the economy slows down, it can help prevent prices from escalating too rapidly.
So by increasing interest rates, the Bank of England can help cool down the economy and keep inflation in check.
However, they must be cautious not to raise rates excessively, or they could risk slowing down the economy too much, potentially leading to unemployment or even a recession.
It’s a delicate balancing act, but it’s all part of the Bank of England’s job to keep the economy running smoothly.
How Lower Interest Rates Stimulate Economic Growth
When inflation falls, prices aren’t increasing as quickly as they used to.
In this situation, the Bank of England might decide to lower interest rates.
When the interest rates drop, borrowing money becomes cheaper. People and businesses might be more inclined to take out loans for big purchases or investments because it costs them less to borrow money.
With lower interest rates, people might also spend more because they don’t get much return from saving money in the bank.
This increase in spending can give the economy a boost, which could help prevent prices from falling too much or even stagnating.
By lowering interest rates, the Bank of England can stimulate economic activity and then encourage spending, which helps the economy keep humming along smoothly, especially when inflation is low.
However, just like with raising interest rates, they need to be careful not to lower rates too much, or they could risk sparking inflation back again or other kinds of economic imbalances.
Therefore, it’s all about keeping the right balance.
How Interest Rate Cuts Affect Savers and Stock Prices
If the Bank of England cuts its rates, then retail banks will follow suit relatively quickly after too.
They don’t really want to be offering more to the customers on savings than the Bank of England rate, and that means that interest rates fall on savings.
Savers and people who want a return on their money need to find somewhere else to put their money; maybe they turn to dividend-paying stocks again.
When a large amount of money seeks a home in a limited number of stocks, prices inevitably rise due to the fundamentals of supply and demand economics.
So saving in cash and being late to interest rates reducing means that you’ll also be late once again if you do eventually decide to move back to dividend stocks, as prices will have potentially risen by that point.
Obviously, this is some oversimplified economics, and there are way more factors at play, but it makes sense.
Ideally, the decision comes down to your time horizon. A common strategy is to keep funds needed within 5 years in high-interest cash accounts (like Trading 212) to avoid market volatility.
However, for capital you can leave untouched for longer than 5 years, a diversified portfolio of dividend stocks is often the better choice for generating real, inflation-beating returns.
What are Real Returns?
Real returns refer to the actual increase in purchasing power or wealth that an investment generates after accounting for inflation.
In simpler terms, it’s the return you get on your investment after adjusting for how much prices have gone up over time.
When you deposit money in a savings account or similar account at a bank, you typically earn interest on that money.
However, historically, the interest rates paid on savings accounts have often been lower than the rate of inflation.
In other words, the money you earn in interest may not keep up with how much prices are rising.
For example, if you’re earning 2% interest on your savings account but inflation is running at 3% per year, you’re effectively losing purchasing power because your money isn’t growing fast enough to keep up with the rising cost of goods and services.
This means that even though you’re earning interest on your cash in the bank, in real terms, your wealth is actually decreasing because it can buy less and less over time.
This is why financial experts often recommend investing in assets that have the potential to provide returns higher than the rate of inflation over the long term, such as stocks, real estate, or other investments.
By doing so, you have a better chance of growing your wealth in real terms and maintaining or increasing your purchasing power over time.
FAQ
Is earning 5% on cash always better than a 3% dividend yield?
Not necessarily. Cash offers fixed certainty today, but it is static. A 3% dividend yield has the potential to grow over time and is often accompanied by capital appreciation (stock price growth), which can lead to higher total returns in the long run.
Why do dividend investors accept lower yields than savings accounts?
Investors focus on the future potential. A 3% yield today can grow into a much higher “yield on cost” as the company increases payouts. In contrast, high savings rates on cash are usually temporary and will fall once central banks cut rates.
How long do high interest rates usually last?
Historically, high rates are a temporary tool used by central banks to fight inflation. Once inflation stabilises, rates are typically cut to stimulate the economy again, meaning high savings yields rarely last for more than a few years.
Can dividend stocks underperform cash?
Yes, it is certainly possible, especially in the short term. Stocks carry the risk of dividend cuts or share price drops. However, while cash is “safe,” it risks losing purchasing power if inflation is higher than the interest rate you are earning.
When should cash be preferred over dividend investing?
Cash is generally superior for money you need within the next 5 years (like a house deposit for example), as you cannot realistically risk losing the value in a market downturn. Dividend investing is better suited for building wealth over longer horizons (5, 10, or 20+ years).