Investing Basics: Income Investing
Do you need your portfolio to generate cash? Is paying your bills and having enough income to live on more important than growing richer? If so, you need to focus on income investing – writes Christian Leeming
Income investing had been out of fashion with investors during the twenty year bull market as some found it almost impossible not to pick winners; however, the COVID-19 crisis makes the future suddenly look far less predictable, with many bracing for a global recession.
Here we take a closer look at income investing; which assets might be appropriate and the most common dangers they might face.
What is income investing
Income investing is the accumulation of assets – shares, bonds, mutual funds, and property – that generate the highest possible annual income with the lowest risk.
Unlike strategies for long term wealth accumulation and capital growth, most of this income is paid out to the investor to fund their everyday living costs; DIY investors are fuelling a surge of interest in income investing and the pursuit of passive income.
The ‘4% rule’ is a rule of thumb for income investors in retirement; to avoid running out of money you should not take more than 4% of the value of your portfolio out each year; it is based on academic research showing that if the market crashes, 5% can run you out of money in 20 years, whereas 3% virtually never did.
Types of investments for an income portfolio
Income investors will typically create three major ‘buckets’ of assets:
Dividend paying shares: Shares in companies that reliably return profits to shareholders with safe dividend payout ratios, meaning they only distribute 40% to 50% of annual profit, reinvesting the rest into the business.
Those not comfortable buying individual shares may prefer to access this income via a dividend paying mutual fund or investment trust.
What to look for in dividend stocks:
- Companies with positive earnings and no losses for the past three years, and aim for a dividend yield of between 2% and 6% – a company valued at £30 paying 60p/£1.80 per share.
- A track record of increasing dividends – shareholder-friendly management, particularly in mature businesses with little growth potential.
- A company that achieves high return on equity (ROE) with little or no corporate debt is a better-than-average business likely to keep paying in a recession.
- Income investing is about protecting your money not punting on risky stock.
- When contemplating funds or investment trusts, look at their historical performance to identify reliable payers
Bonds: There are many types of bonds – corporate, government and savings bonds all deliver ‘fixed income’ – an agreed return on the money you lend them for the duration of the loan.
What to look for, or avoid in bonds:
Bonds are often the cornerstone of an income portfolio as they fluctuate less than stocks; potential profit is more limited than equities but in the event of bankruptcy, you have a better chance of recouping your investment.
However bonds are not without risk and can deliver a unique set of risks for the unwary income investor:
- Retail Bonds issued on the LSE’s ORB exchange have been popular with DIY investors but issuance has been rare; some have been tempted, and devastated, by the siren call of unregulated ‘mini bonds’ – to be avoided at all costs.
- A better choice for the DIY investor may be bond funds.
- Beware ‘duration risk’; don’t choose bonds that mature in more than 5-8 years that are vulnerable to changes in interest rates.
- Generally avoid foreign bonds unless you really understand currencies.
- Another rule of thumb, is the ‘age-old rule’. Aged 30, 30% of your portfolio should be in bonds; at 60, it should be 60%.
Property: Do you want to buy a property outright or invest through a Real Estate Investment Trust – REIT – a company that invests in property?
Each option comes with advantages and disadvantages, but can find a place in a well-built investment portfolio
The advantage of property investing:
If you are comfortable using debt you can dramatically increase your withdrawal rate from your portfolio because whereas inflation erodes the ‘real’ returns on your other assets, a property itself will generally keep pace with inflation.
If you use your capital as a deposit on a property and raise a loan on it, you have a leveraged position on a generally appreciating asset; so, why not invest 100% in property with cheap mortgage money?
Direct property investing is generally more ‘hands on’ than owning shares and bonds, and its tax treatment changes often; if the property market tanks, the loss is amplified, and on an inflation-adjusted basis, the long-term growth in stocks has always beaten property.
The role of saving in an income investing portfolio
Saving money and investing money are very different; even with a diversified portfolio generating lots of cash each month, it is vital to have enough available savings in case of emergency. The precise amount will depend on your outgoings, debt, and influences such as your health and your credit score.
Asset allocation in an income investing portfolio
This is where it gets personal; asset allocation is down to your personal preferences, risk tolerance, and whether or not you can tolerate a lot of volatility.
The simplest income investing allocation would be start with:
- 1/3 of assets in dividend-paying stocks.
- 1/3 of assets in bonds and/or bond funds.
- 1/3 of assets in property
And then adjust it according to your personal circumstances and preferences; these are likely to change over time, and whilst an income portfolio should never be gamey enough to keep you awake at night, it is good practice to schedule a regular portfolio review.
None of these decisions are to be taken lightly because any error or missed opportunity could have a direct bearing on the income investor’s quality of life at a time when they may be at their most vulnerable.
A large number of income portfolios will be showing hefty paper declines because of the recent sell-off; the FTSE 100 gave up 35% of its value in just over a month.
However, as we know, it’s a marathon not a sprint; most will recall the Global Financial Crisis and the Dotcom Bubble, and many will remember Black Monday – or even blacker Tuesday when the FTSE dived by 12.2%, still it’s biggest decline – yet markets have always come back.
As long as you don’t need instant access to your cash, those losses can remain uncrystallised until the market comes back; the key is not to panic, and if you can manage to remain disciplined so as not to eat away at your capital, your income portfolio should be the gift that keeps on giving.