Many investors live off the income from their investments, but they are often unaware of the risks these investments can carry, writes Plato Investment Management's Don Hamson.
Pension-phase investors represent almost one quarter of Australia’s $2.5 trillion superannuation pool, with many seeking a regular investment income to supplement the government pension.
Follow these tips to avoid making common mistakes associated with income investing.
Beware of fake income
While ‘fake news’ is now a common catchphrase, income investors must also be aware of ‘fake income’.
‘Real income’ is the income derived from investments in the form of interest, dividends (including franking credits) and rents. It should not include realised capital gains as these amount to capital returns not income returns.
Some investment funds blur the income/capital definition. For example, annuity income payments usually reflect both income and return on capital.
Similarly, the income distributed from managed funds may represent a combination of real income (comprised of interest, dividends and/or rents) and realised capital gains from increases in stock prices.
Investors needs to tread carefully when it comes to investments that pay out high levels of ‘income’, at the expense of a declining capital value.
Ideally, income should also be ‘real’ in the sense that it is adjusted for the impact of inflation.
For example, the current official overnight cash rate is 1.5 per cent per annum in nominal or pre-inflation terms, but after allowing for the current 1.9 per cent CPI inflation rate, that stock is actually earning a negative real rate of return of -0.4 per cent per annum.
Does high income mean high risk?
Risk and return tend to go hand in hand, and higher expected levels of income may also be indicative of higher risks.
For example, interest rates on debt securities differ due to term or credit risk. Higher yields are generally reflective of longer debt maturities or higher credit risk, or both.
Investments that offer the prospect of capital gains, such as property and equity, often yield less income.
However, in the current period of low interest rates, this can be overcome with growth investments offering higher prospective income potential as opposed to cash or bond investments at a similar risk.
In Australia, our forecast yield on the equity market, including franking credits, is almost four times the current official overnight cash rate of 1.5 per cent and about twice the current 10-year bond yield.
Within equities, income levels may differ due to a range of factors including risk. Some higher-yielding stocks may actually be less risky than very low or zero yield stocks.
This reflects the tendency that small risky growth companies often pay very low dividends, if any, whereas relatively safe and mature companies such as the Australian banks may pay handsome levels of income.
At the same time, a high historical dividend yield (caused by falling share prices) may suggest poor prospects for that company and a high likelihood of dividends being cut in the near future.
In our experience, investment yields that look too good to be true probably are. That is why we proactively try to avoid stocks which likely cut their dividends, or stocks we call ‘dividend traps’.
Diversification, as always, is important
Diversification is a key principle of investing and is also key to good income investing.
Retirees should avoid holding just one risky debt instrument or a single stock as a means of generating income.
Take Telstra, for example. Telstra has been a great income stock for many years, but in 2017, it pre-announced that it would cuts its dividends by 29 per cent in 2018.
Not surprisingly, Telstra’s share price mirrored the future fall in dividends, falling 29 per cent in 2017.
On the other hand, the gross yield of the Australian share market has been remarkably stable over the past 25 years, generally averaging around 5-6 per cent in gross (of franking credits) income.
A diversified portfolio of income stocks or credit exposures is likely to give a more reliable income than investing in a single or very small number of income stocks or credit exposures.
It’s not all about income
In today’s low interest rate environment, few investors have the luxury of being able to solely fund their retirement from the income generated from their investments.
Ultimately, income has to be generated from underlying capital, so most pension-phase investors need to protect – and even grow – their nest egg.
This focus on total return is key to managing longevity risk and, when done well, is why shares play an important role in retirement portfolios.
Even as an income-focused investor, we believe in building portfolios that generate capital growth over the long term, despite the subdued capital growth of the Australian market over the past decade.
Since the start of the 1980s, for example, Australian shares have risen more than tenfold in capital value, with dividend income growth generally keeping pace with that of capital growth.
Shares enable both income and capital growth potential to be captured over the longer term.
How much income should you expect?
With generating income their top priority, a 2017 Plato Investment Management Limited survey found that 29 per cent of respondents expected income greater than 7 per cent from their portfolios, closely followed by 21 per cent of respondents expecting 6-7 per cent, and 29 per cent expecting 5-6 per cent.
These levels can’t be generated by fixed income or typical bank term deposits. It requires dividends to match these expectations – and a smart and sustainable investment strategy.
Don Hamson is the managing director of Plato Investment Management.
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